Description

We believe that FUN offers potential for a ~100% return, with modest downside risk, and identifiable catalysts over the next 18-24 months.

Background

FUN was written up on VIC on November 2, 2009 as a short by PGTenny. We encourage you to read the write-up, as it was well-written, contains some good background information, and was an extremely prescient call at the time. To summarize, the stock was trading ~$10.00 per unit, and the call was that FUN would miss earnings (which they were scheduled to report the next day) and would be forced to suspend their distributions. That thesis turned out to be right on point. FUN missed earnings, suspended their distributions, which coupled with the fear that they would breach covenants on their debt, sent the stock into freefall. PGTenny recommended exiting the position on November 5, 2009, a day when the stock closed at $7.05 (hats off!).  The stock bottomed out at $6.10 on November 11, 2009. Since then, the stock is up almost 500%, currently trading ~$28.00 per share.

In this write-up, we will briefly discuss the business and the industry, dive deeper into why the stock reached $6/share and why it has rebounded so dramatically, and outline why we believe that this stock has the potential for a further ~100% upside over the next 18-24 months.

Business Overview

FUN’s business model is fairly straightforward. They own and operate amusement parks, water parks, and hotels. FUN owns 11 amusement parks, 7 water parks (4 of which are located adjacent to their parks), and 5 hotels (all of which are located adjacent to their parks). We estimate that FUNs top four parks (and associated water parks and hotels) generate over 70% of total company EBITDA. These top four parks are Cedar Point (Sandusky, OH), Knott’s Berry Farm (Los Angeles, CA), Canada’s Wonderland (Toronto, Canada), and Kings Island (Cincinnati, OH).  

Cedar Point is their largest and most profitable park. It was developed in 1870, is believed to be the largest seasonal amusement park in the US, and been named “Best Amusement Park in the World” for 14 consecutive years by Amusement Today’s international survey. The property includes a separate water park, four hotels, two marinas, a campsite, two mini-golf courses, and two go-kart tracks. Knott’s Berry Farm is FUN’s only year round resort. The park attracts over 3mm guests per year, and is most well known for its seasonal events (“Knotts Merry Farm” at Christmas time, and “Knotts Scary Farm” at Halloween). Canada’s Wonderland is the largest amusement park in Canada.

FUN generated $1.0bn in revenues in 2011. The company’s three main sources of revenues are admissions to their parks (~55% of 2011 revenues), sales of food and merchandise (~35%) and accommodations at their hotels (~10%). The expense structure consists largely of fixed costs, with $425mm of operating expenses (primarily maintenance of parks, advertising, utilities and insurance) and $130mm of SG&A expense, in addition to ~$90mm of variable food and merchandise cost of sales. EBITDA was $375mm in 2011, a ~37% margin on revenues.

Industry Characteristics

We would describe the regional amusement park industry as having high barriers to entry, strong and stable cash flows, and proven resiliency during times of economic weakness.

Barriers to Entry

On their recent investor day, FUN management made the point that there hasn’t been a successful new regional theme park built in the US in the last three decades. Intuitively, this makes sense to us as the costs are simply prohibitive. First, there is the cost to acquire/entitle the land. For example, Cedar Point sits on 364 acres of land on the waterfront. Second, there is the cost to build the park. FUN estimates the cost to build a park to be $500mm+.  Additionally, there is the cost to maintain the park. Each year FUN spends over $180mm, or ~18% of revenues on maintaining/enhancing their parks (50% of which is expensed through PNL, 50% of which is capitalized). This number is which includes the economies of scale associated with having 11 parks, which a start up operator would not benefit from.

With very little threat of new competition due to the significant capital barriers, we believe existing regional amusement parks in effect hold local market monopolies, which help to explain the high margins and stable cash flows of the business.

Stability of Cash Flows

Revenue and cash flows of FUNs regional amusement parks proved stable and resilient throughout the recent economic crisis. Below are the last five years revenue and EBITDA for the company.

                Revenue              EBITDA

2007:     $987mm               $341mm

2008:     $996mm               $356mm

2009:     $916mm               $317mm

2010:     $978mm               $359mm

2011:     $1,028mm           $375mm

One can see that revenue and EBITDA actually increased in 2008 v 2007, and during the depths of the economic crisis in 2009, were only down 8%, and 11%, respectively v 2008. Also notably, EBITDA in 2010 snapped back to a level higher than the 2008 peak. What is interesting about the 2009 numbers is that FUN endured terrible weather in their markets during the summer of 2009. It is unclear what the decline in EBITDA would have been had there been good weather, but we believe the numbers above represent the “perfect storm” of economic malaise and bad weather.

We believe the resiliency of the business model is due at least in part to an embedded natural hedge, where during weakened economic conditions, there exists a cohort of people who “trade down” to a day at the amusement park instead of a more extravagant vacation. The positive impact of this cohort largely offsets the negative impact of those who eliminate vacation plans altogether, and mitigates the economic sensitivity of the business model.

FUNs stable financial performance through the crisis gives us comfort that if economic conditions deteriorate, the operating impact to FUN should be manageable.

Why the stock went down to $6.00…

As described above, FUN reached a low of $6.10 per share in November of 2009. This was due to a temporary suspension of distributions to unit holders, which in a stock with a large retail ownership base focused on distribution yield, caused disastrous consequences. The carnage was further exacerbated by the fear of a potential event of default by the company due to weakening core trends in operations.

In order to fully understand the suspension of distributions, we should take a minute and discuss the corporate structure of FUN. FUN is unique in that the business is structured as a publicly traded partnership. As such, they pay out 100% of their excess cash flow in the form of distributions to unit holders. We can think of excess cash flow broadly defined as EBITDA less interest expense, capital expenditures, and debt repayment.

What is important to note here is that the debt repayment component includes both voluntary and involuntary repayments. This is an important distinction. FUNs former credit agreement contained covenants that if EBITDA dropped below a certain level, cash flow otherwise available as a distribution to unit holders would get diverted to pay down debt (involuntary paydown). In 2009, these covenants were breached, forcing FUN to delever. For a stock with a huge retail ownership base, focused on distributions, this had a dramatic impact on the stock price.

Further, the negative trajectory in EBITDA stoked fears that, in the event that EBITDA fell further, more covenants would be breached triggering an event of default for the company. When all was said and done, this did not happen, as EBITDA proved resilient, however these fears are what we believed caused the stock to reach the levels it did in November 2009.

… And why the stock has rebounded to $28.00

Shortly after their Q3 earnings disaster, FUN received an unsolicited offer from Apollo to buy out the company. Apollo was likely attracted to the stable nature of the business, and sensed an attractive entry point with the stock at low levels (the bid was $11.50). Shortly after Apollo’s offer, in January of 2010, hedge fund Q Investments (Sceptor Holdings) filed a 13G showing a >10% ownership stake in FUN. Q Investments and other large holders were not in favor of a deal.  In April 2010, FUN’s Board (which was in favor of the deal) canceled a unit holder meeting where a vote on the acquisition was to be scheduled, and Apollo and FUN ended deal talks. Q Investments and its founder Geoffrey Raynor are still large holders of FUN units.

Separately, in July 2010, FUN completed a refinancing of their outstanding debt, and in February 2011 amended their credit agreement. Taken together, these two actions dramatically lower the cost of interest expense on FUNs debt, and also enhanced their flexibility under their debt covenants, which we will discuss further.

We believe the above developments, in conjunction with the aforementioned snap back in EBITDA in 2010 and 2011 versus 2009, and positive management changes, have contributed to the rise in share price of FUN over the past 18 months.

Why we believe the stock STILL can double from here

In short, we believe that in 2013, FUN can generate $3.55 in free cash flow, which should equate to a normalized distribution of ~$3.00. We believe that FUN should trade at a 5.5% distribution yield, and we arrive at a share price of $55.00, versus the current price of $28.00, or 96% upside from current levels (excluding distributions collected during the holding period).

How we get to $3.55 of ’13 free cash flow and $3.00 of normalized distributions…

FUN generated $375mm in EBITDA in 2011. Their goal is for 2016 EBITDA to be $450mm, which implies a ~4% CAGR over the next five years. Assuming 2012 grows at this average (which we think is conservative), FUN should produce $390mm of EBITDA in 2012. With the debt refinancing, they have lowered their cash interest expense to ~$100mm in 2012 (a decline of over $50mm).  As we discussed, their capital expenditures should run at 9% of revs, or ~$90mm, and their cash taxes will likely be in the ~$20mm range. All else equal, this should result in ~$180mm of cash flow available for distribution before debt paydowns in 2012, or $3.25 per unit.

Management, however, has guided to $1.60 of distributions in 2012E. We believe this discrepancy is largely accounted for in two items, which will depress distributions in 2012, but should be non-recurring in nature. First, there was a $50mm cash payment paid in Feb 2012 relating to an interest rate swap on their prior facility. Second, FUN’s distributions in 2012 are still somewhat limited by the covenants in their credit agreement. Below, we lay out the relevant covenant, the Senior Debt Excess Cash Flow Calculation:

Debt to EBITDA                 % of Cash Flow to Repay Debt

>3.5x                                     50%

3.0 to 3.5x                              25%

<3.0x                                       0%

Senior Debt was $1.156bn at 12/31/11.  Adjusted EBITDA was $375mm in 2011. Therefore, entering into 2012, the ratio for the covenant for FUN was ~3.1x. This means that FUN must use 25% of their cash flow to repay debt in 2012. Importantly, this distribution headwind should go away in 2013, as 2012E EBITDA of $390mm would equate to a Senior Debt to EBITDA ratio of 2.95x, or a level where they can pay out 100% of cash flow as distributions.

In the table below, we show how we arrive at our 2013E estimated free cash flow of $3.55 per share, and our normalized distribution estimate of ~$3.00 per share.

($mm)                 

2013 Adj EBITDA                                    405                        

Cash Interest                                        (100)

Capex                                                   (90)

Cash Taxes                                            (20)

Est Free Cash Flow (2013E)                195

Per Unit                                           ~$3.55

Est FCF (2013E)                                  195

Cash Tax Adjustment                             (15)

Normalized FCF                                   180

Est Normal Distribution %                90%

Est Normal Distribution                      162        

Per Unit                                          ~$3.00

The key drivers are as follows 1) EBITDA growth of 4% from 2012E 2) the swap payment, which was a one-time event in 2012, does not recur 3) cash taxes normalize at $35mm (which will occur in 2015, after NOLs are utilized) 4) the company outgrows its Senior Debt coverage covenant and 100% of cash flow can be distributed to unit holders and 5) FUN distributes 90% of cash flow to unit holders in the form of distributions (from 2003-2008, FUNs cumulative free cash flow before distributions was $637mm, and the cumulative distributions were $587mm, representing a payout of 92%.)

Why a 5.5% yield is appropriate

Historically, FUN stock has traded based on its distribution yield. The table below summarizes the daily average yields for FUN stock, 10 year treasury bonds, and REITs (MSCI US REIT Index), during the period of 1998 through 2007.

As you can see from the above data, FUN traded at an average yield of 6.57% for the 10 year period from 1998 through 2007. This yield represents on average an 181bps spread to the 10 year treasury, and an 86bps spread to REITs. The highest absolute yield for FUN in this data set occurred in 2000, when the average yield was 7.99%. This represented a ~250bps spread to Treasuries, and a ~50bps spread to REITs. In 1998, FUN traded at an average yield of 4.83%, which was 57bps and 102bps tighter than the 10 year Treasury and the REITs, respectively.

At a $28.00 price, the current yield on FUN is 5.7% based on the $1.60 in distributions in 2012. Based on our upside case normal distribution of $3.00, FUN is currently trading at a ~10.7% yield.

Currently, REITs yield ~3.5% and the 10 Year Treasury sits at ~2.10%. Using the average spread from 1998-2007 would imply FUN would be trading at a distribution yield of ~4.0-4.5%!  

We are not going to argue that 4.0-4.5% is an appropriate yield to underwrite to (although we have seen crazier things). Rather, we believe that an appropriate yield for FUN is ~5.5% in an upside case. While this yield is ~100bps lower than FUNs historical avg from 1998-2007, it is not an unprecedented level for the company. Additionally, this yield represents a ~200bps spread to REITs, and a nearly 350bps spread to the 10 year Treasury, both of which are close to historic wide spreads.  In the current environment, where investors are pressed for yield, we believe this valuation makes sense.

Fundamentally, we believe that as the management team rebuilds their track record of distributions (through the implementation of large distribution increases) and investors better understand the resiliency of the business model and the flexibility in the capital structure, the events of 2009 should become a distant memory. We believe retail investors will become re-engaged in the name, the stock will re-rate upward, and the current historic wide spreads will narrow significantly.

Downside Risks

Covenant-Related Risks

In our view, by far the largest risk to the stock is a repeat of 2009, where tripping of debt covenants force distributions to unit holders to be curtailed. First, we ascribe a very low probability to this occurring. Second, if this does occur, there are several reasons why we believe such an event should have a much more muted impact on the unit price.

The relevant covenant for FUN on the downside is the Consolidated Debt to Adjusted EBITDA covenant. This covenant is calculated both including an average revolver balance, and excluding the revolver. Restrictions on distributions are put in place if consolidated debt (i/c average revolver) is >4.75x, or consolidated debt (ex revolver) is > 4.50x Adjusted EBITDA. This is a green light/red light calculation. If above these numbers, FUN can only make a nominal distribution, but if below these numbers, the Senior Debt Covenant (described above) governs the amount of distribution.

At 12/31/11, FUN had $1.561bn of consolidated debt (ex revolver), an average revolver balance in 2011 of ~$60mm, and $375mm of EBITDA. As such, their ratio was of 4.33x using the average revolver, and 4.16x excluding the revolver. The most restrictive covenant (ex revolver) yields a cushion of ~$28mm on 2011 EBITDA. On 2012E EBITDA, we would expect the cushion to grow to $49mm.

The minimum amount of EBITDA under this covenant would be $347mm, or approximately 2007 levels. To breach this covenant would require EBITDA to decline by over 7% from 2011 levels. Note that 2009 EBITDA was $317mmm so a breach would occur at a higher level. Additionally, EBITDA declined by 11% in 2009 v 2008, so a less precipitous decline would also be needed. However, as we described above, 2009 was the perfect storm of economic weakness and poor weather. As such, we ascribe a low probability of a breach, as it would likely require both a severe double dip recession accompanied by unusually poor weather.

Also, it is important to note that even if FUN does breach the consolidated debt covenants, it merely means that distributions to unit holders would be temporarily lowered, and cash would go toward delevering the balance sheet (which would actually make a lot of sense in such an environment). For an event of default to occur, FUN’s EBITDA would need to decline to the ~$260mm level. This level would represent a ~31% decline in EBITDA from 2011, and is ~20% below 2009 EBITDA levels. Therefore, we see the risk of an event of default as remote.

Additionally, we believe that there are a few things that are different now versus in 2009 that would mitigate the impact on the stock price of a distribution suspension, if it were to occur. First, in 2009, the cushion between restricted distributions and an event of default was smaller, and one could not say that the likelihood of an event of default was remote. We had not yet gone through a severe recession and as such the business model was not battle-tested. Additionally, in 2009, the stock traded much more on current distribution yield, and we believe was owned primarily by retail investors. We believe the current investor base better understands the dynamics of a suspension of distributions versus an event of default.

Interest Rate Risks

FUN has $1.156bn outstanding on their 2017 term loan, which has a variable interest rate of LIBOR + 300 with a 100bps LIBOR floor.  FUN has hedged out the vast majority of their interest rate exposure on this debt through the purchase of interest rate swaps. Therefore, the immediate PNL impact of an increase in interest rates is minor. However, increasing interest rates have other indirect impacts on their business and the stock.

First, there could be refinancing risk in 2017, as FUN could be going to the market at a time of higher interest rates, and as such may get a worse execution. We estimate that the swaps cost them ~1.5%, so the all in rate on their term loan is ~5.5%.  Any worse execution on a refinancing would hurt FUNs PNL. However, this will not become an issue until the company starts to think about refinancing in 2016 (if at all).

Secondly, with higher rates, the required yield on distributions would also likely be higher.  In their Jan 25^th Economic Projections, the FOMC consensus is that over the longer run, a Fed Funds rate of 4-4.5% is appropriate. Assuming that the 10 year treasury trades at a 150bps spread to Fed Funds, and FUN trades at a 150bps spread to the 10 year, a normalized required distribution yield in that scenario could be between 7 – 7.5%.  This is not an immediate risk, given the FOMCs stance to keep rates low for a prolonged period. Additionally, with the 10 year yielding 2.10%, and REITs yielding 3.5% as a group, the market believes that this “normal” rate environment is a long ways away, if it happens at all, and there are ways to hedge this macro interest rate risk (Treasuries, corporate bonds, REITs, etc) Finally, in an environment with Fed Funds at 4+%, we would think the economy would be growing very robustly, which one would imagine would have a very positive impact on FUN EBITDA and distributions.

Expected Value Analysis

We arrive at a weighted average expected value of ~$40.00 per share, or ~42% upside from current levels.  See the below table for our expected value analysis.

                                                                                Up                          Base                      Down                    Trip

Normalized Distribution Per Share                               $3.00                     $2.50                     $2.00

Est Distribution Yield                                                   5.5%                      7.0%                      8.5%

Est Unit Price                                                           $55.00                   $36.00                   $24.00                   $14.00

Probability                                                                  40%                        40%                        10%                        10%

Expected Value                                                        $40.00

Est Upside %                                                             42%

Upside Case

We ascribe a 40% probability to our upside case ($55.00 stock). The buildup to the $3.00 in normalized estimated distributions and the 5.5% yield are described above.

Base Case

We ascribe a 40% probability to our base case ($36.00 stock). The differences versus the upside case are estimated distributions of $2.50, and an estimated 7.0% distribution yield. The estimated distributions versus the upside case are haircut for an incremental 300bps increase in the cost of funds for FUN on their 2017 term loan. The distribution yield is based on 4% normalized Fed Funds, a 5.5% 10 year treasury rate, and a 150bps spread on FUNs distribution yield versus 10 year Treasury.

Downside Case

We ascribe a 10% probability to our downside case ($24.00 stock). The downside case incorporates no growth in cash flows from 2011 levels in a normalized environment (versus management guidance of 4% pa), but includes the negative impact of a 300bps increase in cost of funds on the 2017 term loan. This downside case assumes an 8.5% yield on distributions, which is higher than any of the years 1998-2007 for the stock. This downside case produces a valuation of $24.00 or a unit price that is ~14% below current levels.

Trip Case

We ascribe a 10% probability to a case where distributions are suspended (again we believe this would require a severe recession coupled with unusually poor weather). We believe that in such a downside case, the stock could trade to $14.00, however we believe that could present a compelling opportunity to add to the position, as even if EBITDA were to decline by 20% from 2011 (nearly double the decline of 2009 v 2008), FUN would still have a healthy margin of safety with respect to triggering an event of default on their debt. In this scenario, we estimate free cash flow would be ~$75mm, or ~$1.40 per share, which at a 10% yield would equate to an $14.00 share price.

Catalysts

Growth in distributions above markets expectations

Better appreciation/understanding of the level of normalized cash flow/distributions

Retail and other yield-focused investors become re-engaged, and compress the distribution yield of FUN back to historical norms

Catalyst