I don’t believe you should invest on gut instinct alone. But if my bad feeling about a company is backed up by the numbers, then I always avoid a stock.
One company that’s giving me bad vibes at the moment is cinema chain Cineworld Group (LSE: CINE). This FTSE 250 company floated in 2007 as a UK-focused business and was an outstanding success.
However, in December 2017, management struck a deal to acquire US group Regal Entertainment for a total price of $5.8bn. At the time, Cineworld had a market cap of about £1.3bn. To fund this monster acquisition, the company raised £1.7bn by selling new shares in a rights issue and $4bn in new debt.
A high-risk bet?
From a business point of view, this deal may have been a good idea. I don’t have enough industry knowledge to be sure. But what I do believe is that this debt-fuelled deal has introduced a lot of extra financial risk for Cineworld shareholders.
At the end of 2018, the company reported adjusted net debt of $3,935.2m. That’s 3.7x adjusted earnings before interest, tax, depreciation and amortisation (EBITDA). Given Cineworld’s fairly average profit margins, I’d prefer to see this figure below 2.5x.
Operationally, things seem to be going well. So if debt repayment was management’s main focus, I’d probably give it the benefit of the doubt.
Overconfident?
Unfortunately, Cineworld’s management seem to want to have its cake and eat it.
The dividend was lifted by 17% last year and in June the firm announced an additional special dividend of $278m ($0.20 per share).
This cash represents half the $556m the firm has raised through sale-and-leaseback deals on 35 cinemas this year. The idea of the sale-and-leaseback deals was to reduce debt. But leases are a form of long-term liability, rather like debt.
Given how high Cineworld’s debt levels are, I think it’s reckless for management to use cash from property sales for shareholder returns.
CINE stock may seem cheap, on 9.8x forecast earnings and with a 6.1% dividend yield. But if growth slows, I think shareholders could be in for an uncomfortable ride. I won’t be going anywhere near this stock until the picture improves.
I’ve bought this pharma firm
I’m not completely against investing in companies with a lot of debt. One such firm I bought myself earlier this year was FTSE 100 pharma giant GlaxoSmithKline (LSE: GSK).
The shares have risen a little since I bought my shares, but I think the investment case remains strong. There are two reasons why I’m happy to own this stock.
The first is that I expect demand for modern medicines to continue to grow, as new treatments become available and emerging markets become wealthier.
The second reason is that I think Glaxo’s plan to split itself into a consumer health business and a pharmaceutical firm is likely to create value for shareholders. History suggests that two smaller, more focused businesses are likely to perform better than one larger conglomerate.
None of this is certain, but that’s how I expect things to turn out.
The market seems to agree. The rising GSK share price has now pushed the stock’s yield below 5%. I see this as a vote of confidence in chief executive Emma Walmsley’s plans. I continue to view Glaxo as a long-term buy, with long-term income potential.