Dividends on the Ride Down

As I began analyzing amusement-park operator Cedar Fair, it reminded me of a computer game that I used to play called Rollercoaster Tycoon, because I felt like I was on a roller coaster when debating whether to open a position in this company.

Cedar Fair is known as a pure-play, profitable, well-managed company that has paid and raised dividends every year for the past 19 years. Though competitor Six Flags is a pure-play amusement-park operator as well, it lacks all of the other qualities that Cedar Fair brings to the table — it is buried in debt, and its cash flow reminds me of its wilder coaster rides.

Then, several months ago, Cedar Fair revealed its plans to purchase all six Paramount Parks from CBS for a tidy $1.25 billion. That announcement shocked investors, who were attracted to Cedar Fair for its reputation as a relatively low-risk and stable dividend-payer. The stock fell from the low $30s to the mid-$20s, while the dividend yield rose from 6% to 7.6%. Being a sucker for a dividend, I decided to take a peek at the stock. I wanted to find out whether the sell-off was warranted.

The upside of the roller coasterI also knew that Cedar Fair is run by a good, seasoned management team, and that its EBITDA (earnings before interest, taxes, depreciation, and amortization) margins and return on capital are the best in the industry, even exceeding those of the almighty Disney theme parks.

I like the general stability of the theme-park business. It’s not immune to economic downturns, but a trip to a theme park is still one of the cheaper ways for a family to spend time together in the summer, which makes the industry somewhat resistant to rough patches. At the same time, a weaker dollar makes international travel more expensive, so U.S. citizens are more likely to vacation stateside in the first place. Cedar Fair’s theme parks usually serve customers who live within a 150-mile radius, so high gasoline prices are unlikely to have a significant impact.

The Paramount purchase has doubled Cedar Fair’s revenues and diversified the company’s revenue base. It exposed the company to more robust local U.S. economies and even provided foreign exposure, since one of the largest Paramount theme parks is located in Canada. The steep descentAnd then there’s the downside. At the right price, the Paramount acquisition would have made sense. But at the price Cedar Fair paid — 10.7 times EBITDA — the company’s risk profile increased substantially, and the steep price may have limited its ability to further raise dividends for a while.

Let’s look more closely at why I think Cedar Fair paid too much.

1. Increased debt Right around the time of the purchase, Cedar Fair’s $470 million in debt came due for refinancing. Banks, being aware of the company’s increased risk profile after the acquisition, required a higher interest rate from the company for both old and new debt, which significantly raised Cedar Fair’s borrowing costs. The company says it would like to raise $250 million in equity to pay for the acquisition, but it’s not willing to do so at today’s stock price. It may not have a choice, however.
   
   Management said that it can increase merchandise and food sales at the existing parks. If so, that should help increase spending per visitor and raise the new parks’ margins by about 3%-4% over the next several years. If anybody can do it, this management team can, but doing so could prove more difficult than expected.
   
   Assuming the company will be able to refinance a $1.25 billion bridge loan from Bear Stearns and $470 million of its existing debt at 8% — a rate the company says it can get — management will still need to grow food and merchandise sales in Paramount Parks in the low-teen percentages for the acquisition to become accretive in three to four years. It will barely swing by in making its dividend payments, and it will have to make a heroic improvement in the Paramount parks’ performance to be able to raise that dividend.
   
2. Potential for underinvestment in the parks In the past, Cedar Fair prided itself for spending about $55 million a year on capital expenditures — maintaining the parks, improving the rides, and so on. Paramount Parks, meanwhile, spent around $45 million a year. Next year, the company expects to spend $80 million on capital expenditures for Paramount and Cedar Fair parks combined. Part of that expense will go toward adding amenities such as restaurants and shops for the Paramount parks.
   
   Is the new, much higher debt constraining Cedar Fair’s capital expenditures? It’s hard to say. But if so, underinvestment in its theme parks may increase the risk that it will share Six Flags’ financial fate.
   
   Although the Paramount parks are in better shape than Cedar Fair’s previous acquisitions were, management was also very shrewd with its past purchases. They were much smaller and cheaper, and the management team focused on turning around mismanaged theme parks. That’s arguably less difficult than converting a good, above-average group of theme parks like Paramount’s into a great one.
   
3. Limited financial flexibility Before the acquisition — with the exception of the past two years, when it built a water park and converted a Sea World into a water park — Cedar Fair had a nice margin between its free cash flow and the dividend it paid. But the Paramount acquisition has put the company’s ability to pay a dividend, much less raise one, at grave risk. If management is successful at improving the Paramount parks, this acquisition will become accretive in a few years.

But if it fails, or if anything really unexpected happens, the company may become forced to do one of three things:

• Borrow money to pay the dividend, which would further increase its future financial burden.
• Cut capital expenditures, which it would pay for in years to come by way of lower attendance.
• Lower the dividend, which investors would not welcome. The debt Cedar Fair amassed from the Paramount acquisition has made the potential cost of being wrong tremendous. There is little room among the operating cash flows, interest expense, and the dividend payment to soften the blow. The future ain’t what it used to beIt’s easy to say this management team has created a lot of shareholder value, made successful acquisitions in the past, and increased dividends for almost two decades. But investing is a forward-looking activity. Though I’d give the management team the benefit of the doubt, the recent numbers speak for themselves. Cedar Fair’s interest coverage ratio for 2006 (in this case, computed EBITDA divided by interest expense) will have declined from about 7 before the Paramount acquisition to a meager 2.5 or so, assuming the company can obtain the 8% debt financing it says it can. With its 7.7% dividend yield, the stock looks very attractive on the surface. But there’s no such thing as a free lunch. An increased dividend yield (caused by the price decline) has come at a much higher risk. Put simply, Cedar Fair is not the company it was three months ago. I believe that management made a mistake when it hurried to buy Paramount. I suppose I have an excuse now to play Rollercoaster Tycoon, but because of the Paramount acquisition, I won’t be buying Cedar Fair’s stock anytime soon.