The stock of Six Flags (NYSE:SIX) has plunged 48% this year due to some business headwinds, the surge of inflation to a 40-year high and fears that the aggressive interest rate hikes of the Fed may cause a recession. As Six Flags is especially vulnerable to recessions, it will come under pressure in the event of a recession. However, the stock has become so cheaply valued that it can offer a 50% return whenever the economy recovers from its recent slowdown.
The reasons behind the plunge
Six Flags was severely hurt by the coronavirus crisis in 2020, as it was forced to shut down its parks for an extended period. It also had to reduce the capacity of its parks due to social distancing measures. As a result, the company burnt cash at a record pace and incurred a loss per share of -$4.99 in that year. As that loss is 22% of the current market capitalization of the stock, it is certainly excessive.
Fortunately, thanks to the massive vaccine rollout, the pandemic began to subside last year and thus Six Flags posted a material profit per share of $1.50. The pandemic has subsided even more this year and hence the company was expected to grow its earnings to pre-pandemic levels this year. However, its latest earnings report was disappointing. Its revenue dipped 5% over the prior year’s quarter due to a 22% slump in attendance. The average ticket per capita and the average guest spending grew 27% and 23%, respectively, but they were not sufficient to prevent a sharp decrease in the bottom line. Earnings per share declined 35%, from $0.81 to $0.53, and thus missed the analysts’ estimates by an eye-opening $0.48. Consequently, the stock plunged 18% after its earnings release.
The reason behind the daunting performance was the fact that management finally decided to eliminate coupons and offers in an effort to reset the business landscape. As management stated, customers had become accustomed to deep discounts and that had to change at some point. Unfortunately for Six Flags, its product is not essential and hence the demand for its product is greatly affected by the prevailing price. Indeed, while the average ticket price increased 27%, attendance slumped 22%.
The other major reason behind the slump of the stock this year is the war in Ukraine. Some investors may think that the invasion of Russia is irrelevant to Six Flags but this is not the case. The ongoing war in Ukraine has led inflation to skyrocket to a 40-year high. This development has made consumers much more conservative and thus it has taken its toll on consumer spending. As Six Flags relies on the discretionary income of consumers, it is obvious that the demand for the parks of the company cannot remain unaffected by high inflation.
High Inflation also has another effect on Six Flags. It greatly reduces the present value of the future cash flows of the company and hence it exerts great pressure on the valuation of the stock. It is also important to note that Six Flags has eliminated its dividend since the onset of the pandemic and does not intend to initiate a dividend anytime soon, mostly due to its high debt load. As a result, high inflation is a strong headwind for the valuation of this stock. This helps explain why Six Flags is currently trading at a price-to-earnings ratio of only 13.0, a nearly 10-year low valuation level.
Fortunately for Six Flags, the aforementioned headwinds seem to be temporary. The company is doing its best to improve the experience of its customers and thus it has achieved customer satisfaction rates that are much higher than those in 2021. Moreover, guest spending per capita has grown more than 50% compared to pre-pandemic levels. Furthermore, the elimination of deep discounts is healthy from a long-term perspective, as it provides a healthy profit base from which the company can grow.
In reference to inflation, the Fed is doing its best to restore the price index towards its long-term target of 2%. Thanks to its aggressive interest rate hikes, the central bank is likely to achieve its goal and thus inflation is likely to begin to subside next year. Such a development will be great for Six Flags for two reasons. It will have a positive effect on consumer spending while it will also form a tailwind for the valuation of the stock.
Thanks to the recovery of its business from the pandemic, Six Flags is expected to grow its earnings per share by 17% this year and by another 33% next year. If the company meets the analysts’ estimates, it will achieve earnings per share of $2.34 in 2023, 11% higher than the pre-pandemic level of $2.11.
Six Flags is currently trading at 13.0 times its expected earnings this year. Even better, the stock is trading at only 9.7 times its expected earnings in 2023. This is a nearly 10-year low price-to-earnings ratio for the stock.
Six Flags has traded at an average price-to-earnings ratio of 29.4 over the last decade. While it is prudent not to rely on such a high price-to-earnings ratio, one can reasonably expect the stock to revert towards a price-to-earnings ratio of at least 15.0 whenever inflation subsides. If inflation decreases significantly over the next three years, which is the most likely scenario, Six Flags is likely to greatly reward its shareholders. A realistic price target for 2025 is $34 (=15 * $2.34), which implies 50% upside potential over the next three years.
While Six Flags seems deeply undervalued at its current stock price, it also has some risks. First of all, the company is highly vulnerable to the pandemic. If the coronavirus mutates significantly and evades vaccines, it may lead some consumers to stay away from the parks of the company. Fortunately, such a negative scenario is unlikely thanks to the efficiency of vaccines and the sustained efforts of pharmaceutical companies to adjust their vaccines to the new mutations of the virus.
Another risk factor is the weak balance sheet of Six Flags. Cyclical companies should have a healthy balance sheet in order to be able to withstand downturns in their business. Unfortunately, Six Flags has not learnt this lesson yet. In the Great Recession, the company went bankrupt due to its excessive debt pile. Even worse, it did not learn its lesson from that recession and thus it now has a weak balance sheet.
Its interest expense consumes 35% of its operating income and its current liabilities ($640 million), which are due within the next 12 months, exceed its current assets ($263 million). Moreover, its net debt (as per Buffett, net debt = total liabilities – cash – receivables) stands at $3.1 billion. This amount is 170% of the current market capitalization of the stock and 23 times the earnings of the company in the last 12 months and hence it is excessive. Fortunately, the company currently generates sufficient free cash flows to service its obligations but it is likely to come under pressure if a severe recession shows up.
Finally, there is another risk factor. As mentioned above, inflation is likely to begin to subside next year thanks to the aggressive stance of the Fed. Nevertheless, in the unlikely scenario of persistent inflation, the valuation of the stock of Six Flags is likely to remain under pressure, particularly given that the stock does not offer a dividend to mitigate the impact of inflation on the capital of its shareholders.
Due to the aforementioned headwinds, the stock of Six Flags is currently trading close to its 10-year lows. Only at the onset of the coronavirus crisis did the stock trade below its current price. As the above headwinds are likely to attenuate over the next three years, the stock can offer a 50% return during this period.
On the other hand, investors should always remember that Six Flags is not a buy-and-hold-forever stock due to its high cyclicality. As soon as the stock reaches its target price of $35, investors should consider taking their profits.