Shares in FTSE 250 cinema chain Cineworld Group (LSE: CINE) have risen from a market-crash-low of 18p in March to a five-bagging high of 99p in June. Since then, the Cineworld share price has fallen by 50% to around 48p.
At this level, analysts’ estimates value the stock at just three times 2021 forecast earnings. That could be a bargain. But, as I’ll explain, I think anyone tempted by Cineworld’s share price needs to look at the bigger picture. In my view, this stock carries some serious risks for shareholders.
Will things get back to normal?
The first question to ask is whether cinema chains can ever return to normal operation. By normal, I mean high levels of seat occupancy and unrestricted food and drink sales.
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I don’t see this as a big concern. It may seem unlikely right now, but I think history and common sense suggest we will get back to normal at some point — perhaps during the next six to 12 months.
If I’m right, Cineworld could be well positioned for a return to growth. The group is one of the largest cinema operators in the UK and the USA. This provides negotiating power with movie studios and some attractive economies of scale.
Although streaming services such as Netflix are a growing competitive threat, I’d bet people will continue to enjoy going out to the cinema and watching films on a big screen.
Why am I worried about the Cineworld share price?
Given my bullish view on the outlook for the cinema business, you might wonder why I haven’t been buying Cineworld shares ahead of a potential recovery. The reason is that while I think the business will survive, I believe it has too much debt and will need refinancing.
If I’m right, shareholders could see a lot of dilution. In my view, the stock’s 2021 forecast P/E ratio of 3 reflects this risk. I think the market is pricing in a sharp reduction in earnings per share from forecast levels.
Look at the numbers
Even before the pandemic, I didn’t think that Cineworld’s financial situation was ideal. The company’s most recent accounts date from the end of 2019. At that time, the firm had net debt, excluding leases, of $3.5bn. That represents a leverage multiple of 3.5x cash profits (EBITDA).
That was already well above my preferred limit of 2.5x EBITDA. But for a business like Cineworld that generated plenty of cash, it wasn’t a disaster.
Although the firm hasn’t provided any update on its total debt levels this year, we do know that Cineworld has secured some extra borrowing facilities. I think we can safely assume net debt is higher than it was at the end of 2019.
In my view, Cineworld stock is likely to be weighed down by the group’s high levels of debt. I suspect that as trading improves, all available cash flow will be required to repay short-term debt.
I think Cineworld will eventually need to raise fresh cash by issuing new shares. For existing shareholders, this could result in significant dilution. I’d say Cineworld’s share price is about right at current levels. I plan to avoid the stock until we get more clarity on the group’s financial situation.
