Historically, British companies have had a hard time trying to crack the US market. Even Tesco (LSE: TSCO), the UK’s largest retailer, tried and failed to break into the USA. The group admitted defeat in 2013, selling its chain of 199 Fresh & Easy shops in 2013 for a loss of £1.2bn.
Cineworld (LSE: CINE), however, believes it can succeed where others have not. Last year, the company spent $5.8bn to acquire US cinema group Regal Entertainment.
So far, it seems as if the enlarged group is making progress, but I believe investors should stay away.
High-risk bet
Cineworld’s hostile takeover of Regal was a high-risk bet by management. As well as a rights issue, Cineworld took on a staggering $4.1bn in debt to fund the deal.
Today the company revealed its first set of results following the merger, which completed in February. For the six months to the end of June, admissions, revenue and profit before tax, increased 143%, 252% and 165% respectively.
Management is confident that this performance can be repeated in the second half. Indeed, according to CEO Mooky Greidinger, the second half has “started well with the release in July of ‘Mission Impossible: Fallout’, ‘Mamma Mia! Here We Go Again’ and ‘Equalizer 2’.“
But despite the group’s rising profitability, what concerns me is Cineworld’s debt. At the end of June, adjusted net debt was $3.9bn, up from $3.3bn at the end of 2017 and equal to 3.8 times adjusted earnings before interest tax depreciation and amortisation (EBITDA). Generally, when looking for investments, I rule out any companies with debt-to-EBITDA ratios of more than two times.
What’s more concerning is that Cineworld’s debt facilities are subject to floating interest rates. With interest rates rising, it is only going to become more costly for the group to meet its obligations in the months and years ahead.
Considering all of the above, I’m avoiding Cineworld despite its 4.4% dividend yield and relatively low forward P/E of 13.9 (although my colleague Jack Tang seems to disagree).
Growth and income
Instead of Cineworld, I would buy a recovery play Tesco. The UK’s largest retailer has come a long way since its accounting scandal in 2014/15. And now the group is aggressively chasing market share with the launch of a new discount brand to take on the likes of Aldi and Lidl as well as a buying agreement with French retailer Carrefour.
Together, these initiatives should help the group push down prices and push up profits. City analysts are expecting the company to report earnings growth of nearly 30% for fiscal 2019, followed by an increase of 20% in 2020.
At the same time, Tesco’s dividend to investors is expected to more than double to 7.1p, giving an estimated dividend yield of 2.7% at current prices.
Unlike Cineworld, Tesco has also been working on reducing debt over the past five years. Net debt has fallen from £6.6bn to £2.6bn at the end of fiscal 2018, which is around 1.1 times free cash flow from operations (for fiscal 2018).
So overall, with its strong balance sheet and growing dividend, Tesco looks to me to be the better buy. With its mountain of debt, I couldn’t sleep comfortably owning Cineworld.
