Back at the start of 2022, I discussed the question of how much company debt is too much.
I also suggested it would be a good learning experience for readers to follow an unfolding situation in real time. And recommended closely watching developments at cinemas group Cineworld in 2022.
The company’s share price has collapsed in the way I predicted, so now seems a good time to review how and why this happened. I’ll also give you a shortcut for avoiding companies with too much debt in future.
Flashback
Let me briefly recap Cineworld’s position when I was writing in January. The company had last reported net debt of $4.6bn. It was facing a debt covenant test at 30 June 2022, requiring net debt to be no more than five times trailing 12-month EBITDA (earnings before interest, tax, depreciation and amortisation).
It had made a loss in four out of the first five of those months. I said it had “a snowball’s chance in hell” of meeting the covenant test and that its level of debt was unsustainable.
I thought it possible that debt holders could push the company into administration or, only slightly better for shareholders, force it into a financial restructuring involving a debt-for-equity swap. This is where lenders write off a significant portion of debt and are issued with new shares instead.
I wrote: “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.”
Plot development
Let’s look at some of the key developments since January (I haven’t got space to cover them all). Industry box office numbers through the first months of the year suggested Cineworld’s financial position was only getting worse.
The company’s annual results, issued in March, confirmed this. And the directors said uncertainties around future admission levels and the film slate created “a material uncertainty that may cast significant doubt upon the group’s ability to continue to operate as a going concern.”
Net debt had increased a further $200m in the space of six months to $4.8bn.
Horror movie
Lenders had twice waived Cineworld’s debt covenants during the pandemic. These waivers were both announced a month before the test dates. There was no announcement a month ahead of the 30 June 2022 test, and the test date itself came, went and disappeared in the rear-view mirror with still no news lenders had agreed a waiver.
On 17 August, management announced it was considering a number of strategic options, including a financial restructuring that would “likely result in very significant dilution of existing equity interests in Cineworld.”
Five days later, following a weekend report in the Wall Street Journal that Cineworld was preparing to file for bankruptcy within weeks, the company issued another update. It confirmed that one of the options it was considering was a Chapter 11 bankruptcy filing in the US and similar proceedings in its other markets.
In the wake of this announcement, Cineworld’s shares slumped again to trade in that 1.5p-3p area I referred to in January.
Did you see the ending coming?
Predicting the collapse of Cineworld required a number of things. These included an understanding of what industry box office figures meant for the company’s financial performance. Also, knowledge of its debt structure, and the mindset and likely behaviour of lenders. And experience of comparable situations to appreciate what its shares might be worth.
Of course, many small private investors don’t have competencies and experience in such areas. However, sophisticated hedge funds do. And they can provide a useful hack to the question of whether a company has too much debt.
Hedge funds can make a profit by taking a ‘short’ position in a stock — a bet on the share price falling. They’re required to disclose a position of 0.5% or more to the Financial Conduct Authority (FCA). The FCA publishes a daily spreadsheet, but the website shorttracker.co.uk presents the information in a far more digestible way.
Now, not all stocks are shorted because of debt. However, if you have any concerns on the debt front, checking shorttracker is a smart move. Significant short interest in a stock is often a good indicator that the company’s debt may be too high.
Closing credit
As a wise man once told me: “If you can avoid stocks with extreme downside risk, the upside for your shares portfolio will take care of itself.”
