Magic rubs off Merlin as weather takes its toll on profits and the share price

Russ Mould, investment director at AJ Bell, comments:

• “Never pay a premium multiple for a stock where the weather can interfere with short-term trading – because you are paying for predictability yet relying on the unpredictable.

Based on consensus earnings estimates, Merlin was trading on 21 times forward earnings for 2017, compared to a 14.8 times price/earnings (PE) multiple for the FTSE 100 as a whole. That premium can be justified by Merlin’s strong intellectual property (in the form of its brands), powerful market positions and a reliable (if short) trading history since its 2013 flotation. But it leaves the shares very exposed on the downside in the event of a sudden disappointment – and with near-term trading somewhat weather reliant that is always a risk.”

• “There are few worse investments than a growth stock that doesn’t grow its earnings because a loss of confidence and the derating of the stock does more damage to the share price than the profit forecast downgrades.

Merlin had a decent growth record and the analysts’ consensus called for a 3% increase in earnings per share in 2017 and 17% in 2018. Cuts to those numbers will follow although the actual downgrades could be 5% or less in each case, based on management’s guidance for today. But this is why overpaying for growth can be dangerous: estimates are cut and the rating (or multiple) is cut as well because of the disappointment and (upwardly) revised perception of risk. Before today’s warning investors were happy to pay 21 times 21.4p of earnings per share (to get to the 450p share price of yesterday) After a plunge to 364p investors were paying just 17 times the new forecast of 21p in EPS, to reflect how their confidence is lower and how they now think the risks are higher.”

• “Merlin is just the latest FTSE 100 stock to take a pasting after a profit warning.

Pearson in January, Provident Financial (since relegated from the index) in August and ConvaTec in October all fell by a fifth or more in a single day following profit warnings, dividend cuts or both and Merlin has joined this club. Such savage responses suggest investors are becoming more nervous, which makes sense – as stock indices and share prices go higher, valuations become more expensive and the margin of safety on the downside becomes much thinner. What tends to happen near market tops is investors huddle in the few remaining reliable names, overpaying for perceived safety until even these names let them down and then the wider market breaks lower.”

“The table below shows the 20 most expensive and 20 cheapest stocks in the FTSE 100, on the basis of the PE using consensus analysts’ forecasts for 2017.

“Generally, those on the left are seen as having more reliable earnings, dividend streams and growth prospects. They thus more highly prized by investors and are accorded a premium rating. (There are exceptions – Rolls Royce is there because its profits have collapsed so the multiple is inflated, for example).

“Those firms with more cyclical, risky (or even structurally challenged) profits are generally found on the right and come on a discount to the FTSE 100 overall.”

Source: Digital Look, consensus analysts’ forecasts.