The Motley Fool

This FTSE 250 stock just rose 6.7% on a profit warning! Time to buy?

It’s not often a company’s share price jumps when it issues a profit warning. But that’s what happened with Cineworld (LSE: CINE) this morning. Its shares rose as much as 6.7% in early trading after it warned its full-year performance would fall short of expectations.

What was behind the share price rise? And could this FTSE 250 stock, which trades on a modest earnings multiple and high dividend yield, be a top buy for investors today?

Bad news and good

In its update for the 11 months to 1 December, the company told us: “Given weaker box office, partially offset by strong execution of synergies and revenue initiatives, trading for the full year is expected to be slightly below management’s expectations.”

Cineworld’s box office takings fell 12.8%, with declines across all geographies: US (-13.9%), UK & Ireland (-12.7%), and rest of the world (-4.2%). Less drastic declines in food, beverages and other income in the US and UK & Ireland, and a positive performance in this area from rest of the world, mitigated the 12.8% drop in box office. Albeit total group revenue fell a still-hefty 9.7%.

The market had expected a weak box office performance, due to the phasing of major releases and postponement of some highly anticipated movies to 2020. However, there was positive news too.

The company said the integration of Regal is progressing well and announced “an increase in achievable synergies from $150m to $190m.” It also said the US launch of its Unlimited programme in July “has been extremely well received and is well on track to reach membership levels above initial management expectations by year end.”

Set to crash and burn?

However, the initial bounce in the shares hasn’t lasted, and by late morning they’d turned red. I suspect the early spike may have been more to do with the reducing of some of the short positions in the stock than with market enthusiasm for the trading update.

Cineworld has become the most heavily shorted stock on the London market, with 11 institutions holding disclosable short positions totalling 12% of the company’s shares. The true short interest, including positions below the disclosable threshold, is likely to be in the region of one-and-a-half to two times the disclosed percentage.

The level of short interest in Cineworld is as high as it’s been in previous disaster stocks, such as Carillion, Debenhams and Thomas Cook. Why are short sellers so convinced Cineworld’s set to crash and burn?

Debt and vanity

I’d put debt at the top of the list. Cineworld loaded its balance sheet with debt for the mega-acquisition of US chain Regal last year. Prior to the acquisition, it had net debt of £278m and gearing of 1.4 times EBITDA. At the latest balance sheet date, net debt was $3.3bn, with gearing at a whopping 3.3 times EBITDA.

The company’s made inroads in reducing debt, but only at the cost of storing up higher future liabilities by selling some US cinemas and leasing them back. As my colleague James J McCombie suggested yesterday, this could be viewed as “an admission that a king’s ransom was paid for those Regal revenues.” Indeed, I think it could prove to be a vanity acquisition, given years of declining US cinema attendances.

I’m avoiding the stock, as I think you can forget forecast P/Es and dividends when debt and short positions are so high.

You Really Could Make A Million

Of course, picking the right shares and the strategy to be successful in the stock market isn't easy. But you can get ahead of the herd by reading the Motley Fool's FREE guide, “10 Steps To Making A Million In The Market”.

The Motley Fool's experts show how a seven-figure-sum stock portfolio is within the reach of many ordinary investors in this straightforward step-by-step guide.

Simply click here for your free copy.

G A Chester has no position in any of the shares 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.