Cineworld shares are up 273% in 8 months. Am I too late to buy?

The Cineworld share price has soared on vaccine and reopening prospects. G A Chester weighs the upside potential and downside risk today.

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In 2020, Cineworld‘s (LSE: CINE) share price sank to lows never before seen in the company’s 13-year stock market history. However, sentiment has since improved. The shares have soared from 24.3p eight months ago to 90.7p.

Have I missed the boat? Or could there be a lot more to come? After all, the shares traded as high as 350p a few years ago.

Catastrophe risk

Warren Buffett has said: “I’m always looking at the downside on something first. I mean, if you can’t lose money, you’re going to make money.” I think Buffett’s policy is a good one, and it’s one I try to follow.

At Cineworld’s current share price, its market capitalisation is £1.2bn ($1.7bn). Set against this, its level of debt looks extremely high. Year-end net debt (excluding lease liabilities) stood at $4.3bn. That’s worrying enough for me, but it goes up to an eye-watering $8.3bn when lease liabilities are included.

What would happen in the event of renewed restrictions or lockdowns, say because of a virus mutation that’s resistant to current vaccines? For a company with as much debt as Cineworld, the outcome for shareholders could be catastrophic.

Can Cineworld trade out of trouble?

Excluding a disaster scenario, Cineworld’s debt is still highly problematic for me as a potential buyer of the shares. In the pre-pandemic year of 2019, the company made an operating profit of $725m. But 78% of this ($568m) went to servicing its debt. Last year, due to an increase in borrowings of more than $1bn, the cost of servicing the debt rose to $787m.

An operating profit of $725m in the last normal year’s business and interest payments currently running at $787m don’t look to me like a great starting point for trying to trade your way out of trouble. As such, I see a relatively high risk of a major financial restructuring and painful dilution for existing investors.

Upside potential for Cineworld shares

Cineworld may be able to avoid a restructuring, if it can slash its cost base and produce materially higher operating profits than the cost of servicing its debt. And the current reopening trajectory, with evidence of pent-up demand and a strong slate of delayed film releases, is helpful.

One or two of my Motley Fool colleagues are positive on the stock. Indeed, Cineworld bulls can look back at that previous 350p share-price high and argue that the potential upside reward is worth the downside risk, and that I’m not too late to buy.

Headwinds

However, even if Cineworld can avoid a financial restructuring, I think it could take some time to strengthen its balance sheet. And longer still to resume the dividends that were once a big draw for investors.

Several headwinds won’t help Cineworld or its shares. There’s been a two-decade structural decline in cinema-going in the US (Cineworld’s largest market by far). Film studios are shortening the windows of theatrical exclusivity. And streaming services like Netflix are providing rising competition to the traditional way of consuming movies.

My bottom line on Cineworld shares

At the end of the day, Cineworld’s millstone of debt and the challenges it faces in servicing it, are a deal-breaker for me. I’ll revisit the company when it releases its half-year numbers, but for now, I’m avoiding the stock.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

G A Chester has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Netflix. 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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