Why You Should Avoid Six Flags (NYSE:SIX)

Six Flags Entertainment Corporation (NYSE:SIX) may appear attractive assuming a recovery in EPS, but risks remain high.

Overview

Six Flags Entertainment Corporation is the largest regional theme park operator in the world and the largest operator of water parks in North America. Six Flags operates 26 regional theme parks and water parks with 23 in the U.S., 2 in Mexico, and 1 in Montreal, Canada.

I first became attracted to Six Flags, as the Company reports high returns on invested capital (ROIC). Return on invested capital measures the efficiency of how well a company is using its capital to generate profits. This measure is extremely important for long-term investors as returns will tend to track towards the company’s ROIC in the long term. Companies with high ROIC tend to have a competitive advantage or economic moat that allows that company to generate excess economic profit.

Six Flags operates in a moderate to high barrier to entry industry (with large land requirements and regulatory approval). Management is not shy about this fact as the 2020 Six Flags Annual Report outlines “We believe our parks benefit from limited direct theme park competition.” High barriers to entry deter competitors from entering Six Flags’ markets and support Six Flags’ healthy returns on invested capital as evidenced below. Note returns on invested capital below are derived from my internal calculations and are calculated as management’s Adjusted EBITDA from the June 2021 Investor Presentation taxed at 25% (to compute NOPAT) and invested capital is based upon the total debt and equity derived from the company’s 10Ks.

	2013	2014	2015	2016	2017	2018	2019	2020
ROIC	9.28%	11.96%	14.09%	15.15%	15.02%	16.30%	14.51%	-12.86%

For obvious reasons, Six Flags took on losses and struggled during COVID-19, but long-term, the business fundamentals remain operationally healthy and strong. Moreover, if you assume Six Flags returns to its 2017-2019 EPS figures, it appears much more attractive from a valuation perspective. The chart below shows Six Flags’ revenue, EPS, and current P/E multiple on past earnings (revenue and EPS were derived from the company’s 10Ks).

	2017	2018	2019	2020	2021
Revenue	$1.36B	$1.46B	$1.49B	$0.36B	$1.50B
Basic EPS	3.15	3.28	2.12	(4.99)	1.52
P/E Multiple	13.87x	13.32x	20.60x	N/A	28.74x

However, return on invested capital assesses the profitability of the operations of a business before the impacts of financing (or debt) and EPS figures can be misleading with high leverage. In recent years, Six Flags has steadily taken on more leverage.

Six Flags’ Leverage

Management targets a net debt to adjusted EBITDA of 3x to 4x and management remained within that target from 2013 to 2019 with both increasing debt and EBITDA. Six Flags’ debt levels from 2013 to 2019 increased at a steady rate of 9.3% per year while revenue and adjusted EBITDA only increased 5.0% and 4.5% per year, respectively. Therefore, management’s investments did not yield enough return on investment to exceed the growth of the debt incurred, which had the effect of tilting the capital structure to have a heavier debt weighting over time. Below is the net debt, adjusted EBITDA (per management’s June 2021 Investor Presentation), and net debt to adjusted EBITDA.

	2013	2014	2015	2016	2017	2018	2019	2020
Net Debt	$1.23B	$1.32B	$1.41B	$1.52B	$1.94B	$2.06B	$2.1B	$2.46B
Adj. EBITDA	$404M	$439M	$481M	$507M	$519M	$554M	$527M	($231M)
ND/ Adj. EBITDA	3.05x	3.01x	2.92x	2.99x	3.75x	3.72x	3.99x	NA

For 2021, net debt of $2.29 billion and adjusted EBITDA of approximately $95 million resulted in a net debt to adjusted EBITDA ratio of 24.15x. Leverage amplifies returns in good times and losses in bad. However, Six Flags, and more broadly theme parks, are discretionary expenses that are first to be cut by consumers in an economic downturn. Therefore, Six Flags’ business is both cyclical and highly levered, which amplifies the volatility of the equity. This is evidenced by Six Flags’ 5-year beta of 2.32. Moreover, Six Flags’ cyclicality makes management’s debt to EBITDA target of 3x-4x a bit of a moot point since EBITDA can swiftly swing negative from economic turbulence. A better way to view Six Flags’ debt is assessing the debt to market value of invested capital (MVIC). Market value of invested capital is the market value of owners’ equity plus the interest-bearing debt. The following displays Six Flags’ capital structure based upon the debt as of January 2, 2022.

	$	%
Market Capitalization	$3.79B	59.0%
Total Debt	$2.63B	41.0%
Market Value of Invested Capital	$6.42B	100.0%

At over 40% debt financing, Six Flags’ leverage remains high. To put it in perspective, I analyzed Aswath Damodaran’s WACC by Industry data, which compares the debt and equity weightings by industry (as measured by market value). Aswath Damodaran includes Six Flags in the Recreation industry, which includes a variety of leisure and discretionary-related businesses. The Recreation industry reported a debt to market value weighting of 22.8%, putting Six Flags far above the industry average.

Valuation

So how should Six Flags be valued given its high leverage? One way would be to model out Six Flags’ debt payments from cash flows. However, it is uncertain how much debt management will pay down since the more likely scenario is largely a recovery in EBITDA that puts the debt to EBITDA ratio in line with management’s target. I would also argue this strategy adds additional risk premia to Six Flags’ “normal” cost of equity given management’s intent to keep leverage high (or less than optimal). Alternatively, I decided to value Six Flags using an estimated optimal debt weighting of 25% (rounded) for the leisure and discretionary industry. For the cost of equity, I utilized a 10% return. For the cost of debt, I utilized the weighted average cost of interest for 2021 of 6.3% (4.8% after-tax), which may be conservative given the recent rise in rates. Using a 25% debt weighting, this resulted in a weighted average cost of capital of 8.70%.

To model the discounted cash flows, I utilized the following assumptions:

• Revenue is anticipated to grow with inflation estimates from the Survey of Professional Forecasters inflation estimates of 3.7%, 2.7%, and 2.3% for 2022, 2023, and 2024, respectively. Growth of 2% is estimated for the terminal period.
• EBITDA margins are estimated at 36%, which is derived from the average EBITDA margins of 2013-2019.
• Depreciation is estimated at 7.5% of revenue, which is derived from the average depreciation expense to revenue from 2013-2019.
• Capital expenditures are estimated as the average capital expenditures to revenue from 2013-2019.
• Changes in net working capital are estimated to grow at the same rate as revenue from the 2021 levels.
• NCI income is forecast to be the same percentage of revenue as 2021.
• Taxes are estimated using a normalized tax rate of 24%, which is approximately the average effective tax rate from 2013-2021.

The DCF assumptions result in the following cash flows:

	2022	2023	2024	Terminal
Revenue	$1,555,659	$1,626,014	$1,724,349	$1,870,994
Opex	(995,622)	(1,040,649)	(1,103,583)	(1,197,436)
EBITDA	560,037	585,365	620,766	673,558
Depreciation	(116,674)	(121,951)	(129,326)	(140,325)
Income Taxes	(106,407)	(111,219)	(117,945)	(127,976)
NOPAT	336,956	352,195	373,494	405,257
Less: NCI Income	(43,405)	(45,368)	(48,112)	(52,204)
Less: Chg. in NWC	(4,057)	(4,857)	(6,789)	(10,125)
Add: Depreciation	116,674	121,951	129,326	140,325
Less: Capex	(149,343)	(156,097)	(165,538)	(179,615)
FCF to Invested Capital	256,825	267,822	282,381	303,638
PV Factor	0.91999	0.84638	0.77866
PV of Cash Flows	236,276	226,679	219,879

Finally the following summarizes the valuation summary.

PV of Cash Flows	682,834	Terminal Cash Flows	303,638
PV of Terminal Value	3,530,394	Cap Rate	6.70%
Enterprise Value	4,213,228	Terminal Value	4,533,941
Less: Debt	(2,680,078)	PV Factor	0.77866
Value of Equity	1,533,150	PV of Terminal Value	3,530,394
Shares Outstanding	85,708
Price Per Share	$17.89

To be honest, I was initially surprised to arrive at such a low value for such a modest rate of return. However, high leverage creates large disparities in equity values depending upon investors’ return expectations. Below are the same valuation assumptions as above with only changing the cost of equity.

Cost of Equity	5%	6%	7%	8%	9%
Price Per Share	$81.28	$58.30	$43.08	$32.26	$24.17

It appears the market is currently pricing in returns around 7% for Six Flags’ equity, assuming a return to a more normalized level of debt. However, since Six Flags is not pursuing a reduction in their long-term debt target, a higher discount rate should be warranted.

Conclusion

Given the valuation above, Six Flags remains too risky to warrant an investment for long-term investors until management focuses on reducing Six Flags’ long-term debt target. While management indicated their priority is to pay down debt in the February 2022 conference call, they did not specify a change in their long-term debt to adjusted EBITDA target. Six Flags has the potential to be an attractive deleveraging play given its high returns on invested capital, but it remains to be seen at this point. In the meantime, I would watch the volatility from the sidelines.