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Why I’m considering buying this falling knife after today’s 10% decline

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Shares in Cineworld (LSE: CINE) are sliding today after the company announced that it is pursuing the acquisition of US peer Regal Entertainment for a total of $3.6bn. 

Regal is the second-largest cinema operator in the US, so any deal would be transformative for Cineworld. However, the offer of $23 per share currently being discussed values Regal at 50% more than Cineworld’s own market capitalisation. 

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To help fund the deal management is contemplating using a “mixture of incremental debt and a material equity raise by way of a rights issue, ” and it would appear that the prospect of this is what has spooked the market today. 

The company has not published any figures yet, as the merger discussions are still in their early stages, but considering the size of Regal, it’s clear that any rights issue would require hundreds of millions, if not billions from investors. 

That being said, Cineworld’s largest shareholder Global City Holdings NV, which owns 28% of the business, has already voiced its support for a cash call. Management believes that the “proposed financing of the potential transaction will allow the enlarged group to continue its current strategy of investment in the business, as well as to maintain its policy of progressive dividends.

A record of acquiring well 

Even though the market does not appear to like the proposed deal, I believe that this could be a great combination. Cineworld has a history of acquiring peers to boost its growth, and so far, the company has proven itself to be highly adept at this strategy. 

For example, in 2014 it offered £503m for Cinema City International, a Warsaw-listed chain with screens in seven countries across central and eastern Europe. This deal, along with the firm’s other growth initiatives and a string of successful films, helped Cineworld report record visitor numbers of over 100m for 2016, up 7% year-on-year. Growth has continued this year. Net profit and reported earnings per share have grown at an annual rate of 28% and 15.1% respectively for the past six years. 

Assuming that the company can repeat this performance, I believe that the stock is an excellent buy at today’s levels. Shares in the company currently trade at a forward P/E of 15.4, a high multiple but one that looks appropriate considering the company’s historical growth. If Cineworld can continue to chalk up mid-teens earnings growth, earnings per share could hit around 50p by 2020, giving a forward (2020) P/E of 12. 

Waiting for more clarity 

Of course, these figures do not account for the acquisition of Regal, which is still an unknown. Regal has been struggling with falling revenues recently, and this has hit the company’s stock price, so Cineworld is getting a bit of a deal. 

However, Cineworld will have to work hard to turn the company around and prove that it was a good buy. I believe that the firm can do this based on it past deals, but trying to put a value on the enlarged group is not possible as of yet. Still, I’m willing to back this proven value creator as it continues to take over the world. 

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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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