Cineworld: An acquisition that could be a gamble

As a rule, companies operating in the consumer discretionary segment are risky investments during macro-economic downturns since they are likely to witness demand drops as consumers focus on essentials. In that vein, the UK-listed cinemas chain Cineworld (LON:CINE) should be an iffy bet, especially since the economy actually shrank by 0.4% in April.

But this is a unique case, in that 75% of its business is generated in the US, whose economy is in a robust place and its prospects look better than those of the UK. The latter, together with Ireland accounts for only 15% of the revenues.

And indeed, the latest full-year results for 2018 showed that the US focus has reaped benefits. The company’s revenue rose by 7.2% in 2018 and earnings before interest, taxation, depreciation and amortisation (EBITDA) increased by 9.4%. US revenue, in particular, grew by 8.6% and EBITDA by 13.2%. The UK and Ireland also showed revenue growth, of 3.3%, but a decline in EBITDA of 3.7%.

Ambitious acquisition

If this was the sum and substance of the Cineworld story, it would be a definite buy, especially given the recent share price correction. But there’s a twist in the tale. It acquired US-based Regal Entertainment in 2017, which increased its net debt to EBITDA levels to 4x during the year, a cause of investor concern. And that is not all, its latest trading update is most disappointing as well.

But first, the acquisition.

Expansion in the US can be good in so far as the North American market (USA and Canada) accounts for over 70% of the total according to the Motion Picture Association of America. While the extent of debt was discomforting, Cineworld remained optimistic with a target of a 3x ratio by mid-2020. At the end of 2018 it looked like the goal was achievable as the level had dropped to 3.7x.

Rising red flags

However, the recent announcement of a sell-off of 17 US cinemas for a cash consideration of £222m and lease back of the same for 15 years raises red flags. But the news takes on greater gravity given that it came in along with a trading update which shows a whole 9.4% decline in revenue from January-mid-May 2019. While the company attributes it essentially to a base effect, as the same time in 2018 was quite strong, the argument does not sound entirely convincing now.

It is worth noting though that the share price actually inched up in the days following the announcements, before plunging at the end of May. This suggests that investors were not disappointed by the announcements. Nevertheless, it no longer looks like a blind buy.

Download and read the fundament investment case for Cineworld by Vision Research via our research marketplace.