Are Cineworld shares worthless?

I’m often asked questions about investing by family and friends. One that cropped up over Christmas was: “Great investors like Warren Buffett say they avoid companies that have too much debt. But how much is too much?” 
 
It’s an important question, because too much debt can result in a financial restructuring that leaves existing shareholders owning a small fraction of the refinanced company. Or, in a worst-case scenario, suffering a complete wipeout of their capital. 
 
I could talk about past cases, like Thomas Cook, Carillion and Debenhams. But following a real-time unfolding situation is probably the best way to enhance your ability to judge how much debt is too much. 
 
To this end, I recommend closely watching developments at FTSE 250 cinemas group Cineworld (LSE: CINE) in 2022. 
 
Here, I’ll outline the current position of the company and what to look out for as the year progresses. 

Setting the scene

Cineworld was a heavily indebted company before the pandemic, due to its $5.8bn mega-acquisition of the second-biggest US chain, Regal Entertainment, in 2018. 
 
What’s more, in the winter of 2019, it agreed a debt-financed $2.1bn takeover of Canada’s largest operator, Cineplex. Although it aborted this when the pandemic struck, net debt was nevertheless substantial at $3.5bn (excluding lease liabilities). 

Jump cut

Fast-forward to Cineworld’s latest results (for the half-year ended 30 June). Net debt had ballooned to $4.4bn, with $4bn of lease liabilities on top.  
 
Trailing 12-month financing costs were $770m. To give this some perspective, the company’s profit before financing costs in the pre-pandemic year of 2019 was $725m. On these numbers, Cineworld’s level of debt is unsustainable.

Close up

Focusing on the near term, the balance sheet at the half-year end showed current assets of £0.6bn but current liabilities of £1.8bn. ‘Current’ refers to the 12 months from the balance-sheet date. In this case, the period to 30 June 2022. 
 
It means that if Cineworld retained its level of cash and received all the money owed to it in the 12-month period, it would be $1.2bn short of paying all the money it owes in the same period. This is called ‘negative net current assets’. 
 
Not all pandemic-hit companies are in a position of such weakness. Some even have positive net current assets. For example, Premier Inn owner Whitbread (+£0.6bn) and airline easyJet (+£1.5bn). 

The unfolding story

Cineworld’s lenders have already waived or amended a number of operating and financial covenants. Without this, the company would have failed to meet its obligations, and given its lenders the right to call a default and enforce early repayment of the debt. 
 
The current covenants will be tested at 30 June 2022 when net debt is required to be no more than five times EBITDA (earnings before interest, tax, depreciation and amortisation). 
 
The July-to-September quarter was a washout for Cineworld. And while it did report a positive performance in October, with revenue at 90% of the October 2019 level, it neglected to mention that October 2021 contained five weekends versus four in October 2019. This will have reversed in November. 
 
As things stand, with four loss-making months out of the first five, the likelihood of Cineworld avoiding breaching its 30 June net debt-to-EBITDA covenant is in the territory of a snowball’s chance in hell. 

A further twist

To make matters worse, since the last half-year end, Cineworld has taken on a further $200m of loans, and lost two litigation cases. It has to pay $262m compensation in connection with the Regal acquisition, and has an award against it of $970m for pulling out of the Cineplex acquisition. 
 
It intends to appeal the latter judgement. Well, it can hardly do otherwise. 

Denouement

If and when Cineworld breaches its 30 June net debt-to-EBITDA covenant, lenders could call a default, leaving the company’s shares worthless. 
 
It’s possible, but a more likely scenario is for lenders to insist on a financial restructuring involving a debt-for-equity swap. This is where lenders agree to write off a chunk of debt in exchange for new shares. 
 
Typically, in these situations, existing shareholders are left with only marginally better than worthless shares. 
 
At 32p a share, Cineworld’s current shareholders are collectively sitting on value of £440m. Based on experience, I’d expect to see this drop to somewhere in the region of £20m-£40m (1.5p-3p per share) in a debt-for-equity restructuring. 

Bonus footage

I’ll aim to revisit developments at Cineworld in the future. But to begin 2022 on a more optimistic note, there are plenty of reasonably priced UK companies with strong balance sheets for me to write about in the coming weeks.

Happy New Year!