Investors in Cineworld (LSE:CINE) are understandably horrified this week after the shares collapsed by almost 40% on Wednesday. The stock price has since recovered a small amount of this decline. But even with that, the 12-month return generated by these shares now stands at a disappointing -50%. What happened? Is this the start of the company’s ultimate demise? Or is now the perfect time to start buying? Let’s explore.
The devastating power of a lawsuit
To understand what happened this week, I need to go back to December 2019. Cineworld had just signed a $2.8bn acquisition deal to purchase Cineplex, a Canadian cinema chain. The deal was supposed to close by mid-2020, and it would make Cineworld the largest cinema company on the planet.
At the time, this deal sounded fantastic. It once again allowed the company to expand its international operations, delivering even more growth to investors. Yet, as many already know, this deal never happened. That’s because, in June 2020, management announced the agreement was off, leading to an onslaught of legal proceedings.
Cineworld claimed that Cineplex had breached the terms of the signed contract. Without knowing the exact details of the agreement, it’s hard to say if the claims are true. But, if I were to speculate, I think the likely cause for the sudden pull-out had more to do with the global pandemic that decimated the business, which was now in full save-money mode.
It seems the courts agree with my view because, on Wednesday, the Ontario Superior Court of Justice ruled in favour of Cineplex. It awarded the firm CA$1.23bn while simultaneously dismissing Cineworld’s counterclaims. That’s obviously not the outcome Cineworld’s investors were expecting, and Cineworld shares crashed as a consequence. Management unsurprisingly disagrees with the verdict and has begun appeal proceedings. But how long this will take or whether the ruling will be changed is entirely unknown at this stage.
What happens to Cineworld and its shares now?
For the moment, nothing really changes. At least not yet. While the appeal proceedings continue, Cineworld has stated they won’t be making any payments to Cineplex. If the appeal is successful, then Cineworld shares will most likely surge to reverse this week’s downfall. But what if the appeal efforts fail and Cineworld has to cough up?
I’ve been following this company throughout the pandemic. And before this week, things started to look like they were finally heading in the right direction. In the latest earnings report, the success of many delayed blockbuster titles resulted in October UK revenues growing by 27% versus pre-pandemic levels. Meanwhile, international performance has also been catching up and is now close to returning to 2019 levels as well.
But after taking on considerable debt to stay afloat in early 2020, most of the profits are being gobbled up by interest payments on loans. And with only $437m of cash on its balance sheet, Cineworld will likely once again have to load up on even more debt to pay the Cineplex fine. Needless to say, this is a serious problem. And one that could lead to insolvency.
Management still has several levers at its disposal to raise capital through equity or property sales. So, it’s still possible for the company to make a comeback. However, with the current state of the balance sheet and some significant restructuring required, I personally wouldn’t touch Cineworld shares with a 10-foot pole.