Cube Midcap Report (16 Dec 2019) – Credit roll gets longer at #CINE #CHG #SPD

Cube Midcap Report (16 Dec 2019) – Credit roll gets longer at #CINE #CHG #SPD

Good morning, it’s Roland here with the Midcap Report.

On my list to look at today are:

  • Cineworld (CINE) – another jumbo acquisition for this FTSE 250 cinema group
  • Chemring (CHG) – full-year results from this defence specialist
  • Sports Direct (SPD) – half-year results from Mike Ashley’s group.

This report should be finished by 11.30.

Cineworld (CINE)

  • Share price: 200p (-3%)
  • Market cap: £2.7bn

Proposed C$2.8bn acquisition of Cineplex

Cinema group Cineworld was a roaring success for investors when it was a UK/Europe-focused business running chains such as Picturehouse and Cineworld. Things got a little more interesting when the group splashed out $5.8bn to buy leading US chain Regal early in 2018.

CINE share price chart

Source: Google Finance

Management have now upped the ante once more with a C$2.8bn ($2.1bn) deal to buy Canadian chain Cineplex, which is described as Canada’s largest cinema operator, with 1,695 screens and a 75% box office share.

Naturally the deal is being funded with other people’s money. Debt levels are expected to rise again. It’s good news for the group’s ambitious management. But what should shareholders make of this deal? Let’s take a closer look.

US expansion

Before taking a look at this new acquisition, I think it’s helpful to understand Cineworld’s current situation and recent financial performance.

Last year’s deal to acquire US group Regal added more than 7,000 screens to the group’s c.2,200-screen estate in the UK and Europe. But this acquisition also added $4bn of debt to the group’s balance sheet and required a £1.7bn rights issue. The combined group was levered at 4x EBITDA at completion, although this had been cut to 3.3x LTM adjusted EBITDA by the end of June 2019.

This debt reduction equated to a reduction in net debt from $3.8bn at the end of 2018 to $3.3bn at 30 June 2019. It sounds impressive, but the company completed sale and leaseback transactions worth $556m during the same period.

I’d argue there was no real debt reduction in H1. In my view, shifting the burden from debt to leases is effectively just extending the term of the loans, while sacrificing valuable freeholds. And a net debt/EBITDA ratio of 3.3x is still pretty high.

Slowing momentum?

Cineworld is run by Moshe and Israel Greidinger, who are respectively CEO and deputy CEO. The Greidingers are also the controlling shareholders of Global City Holdings, which has a 29% stake in Cineworld.

This ownership stake might explain why the company decided to declare a special dividend $278.1m in H1. To me, this seemed inappropriate in the face of such high leverage. CINE’s ordinary dividend already provides a yield of c.6%. If I was a shareholder, I would want management to place greater priority on debt reduction at this stage, especially as the performance of the business has weakened this year.

Cinema profits are reliant on a good supply of blockbuster hits. The group’s H1 results blamed the timing of major releases for a 14.4% drop in pro forma admissions and a 11.8% reduction in pro forma adjusted EBITDA. (I’d normally avoid such a contrived measure of profit, but in this case it allows us to make a useful comparison.)

At the half-year mark, management were still confident of hitting full-year expectations due to major releases expected in H2. But Cineworld’s latest trading update, earlier in December, included a minor profit warning.

In fairness, Cineworld does seem to generate plenty of cash. But it’s spending a lot too, and remains highly geared. Prior to today’s news, my view was that the stock was fully valued on 10x earnings and was arguably paying out too much in dividends.

That’s the story so far. How does today’s news affect the situation?

An opportunistic buy?

Canadian group Cineplex is listed on the Toronto stock exchange. Cineworld has offered to pay $34 per share for the group, whose shares closed at $24 on Friday.

The acquisition would value Cineplex at 6.3x 2019 forecast EBITDA including expected synergies. This forward-looking approach is popular at the moment.

For context, I estimate that Cineplex’s trailing 12-month EBITDA is C$555.7m. So based on historical earnings, the acquisition values Cineplex at 5.1x TTM EBTIDA. So profits are expected to fall this year.

I don’t have time for a detailed look at Cineplex. But the shares are down by more than 50% from their C$53 high in 2017, when the group reported a sharp drop in profit.

Indeed, Stockopedia stats suggest Cineplex’s profit margins have been in decline for several years, falling from 12% in 2015 to 7.7% in 2018. Return on capital employed is shown as having fallen from 12.9% to 8.8% over the same period.

Is today’s bid from Cineworld bid a timely grab for a good business that’s going through growing pains? It’s possible, I guess.

Big synergies

Like Cineworld, Cineplex appears to be highly geared but has strong free cash flow. So the two could be a good match. Indeed, it seems fair to assume that combining US and Canadian cinema groups should be a decent fit. Cineworld’s management certainly expect to achieve some significant benefits:

  • $130m pre-tax benefits expected by end FY2021
  • Double-digit accretive to earnings and free cash flow in FY2021
  • ROIC expected to exceed Cineworld’s cost of capital in FY2020
  • Pro forma leverage of 4x EBITDA at year-end 2019 is expected to fall “towards 3x net debt/EBITDA by end of FY 2021”

The progress made to date with the integration of Regal suggests to me that these estimates should be credible.

My view

Cineworld bosses Moshe and Israel Greidinger could on the way to creating one of the world’s greatest cinema groups. But they could also be empire-building at the (eventual) expense of shareholders. I don’t know.

The company intends to apply its proven operating model to the combined group, generating significant cost saving and hopefully longer-term growth.

However, returns on capital at both Cineworld and Cineplex look pretty average to me. And integrating two such large acquisitions in three years is likely to be challenging.

Although the high dividend yield is tempting, the level of leverage involved rules this stock out for me. I’m going to remain neutral here.

Sports Direct International (SPD)

  • Share price: 427p (+18%)
  • Market cap: £2.2bn

Half-year results

The Sports Direct share price is up by nearly 20% this morning, following the publication of the group’s half-year results. It’s something of a turnaround for the firm’s billionaire founder Mike Ashley. Mr Ashley’s decision last year to acquire House of Fraser and a string of smaller retailers has made him a contrarian figure, to say the least.

Today’s figures suggest to me that Mr Ashley’s strategy could yet be vindicated.

  • Group revenue: £2,043.5m (+14%)
  • Gross margin: 43.8% (+2.3%)
  • Reported pre-tax profit: £193.4m (+160%)
  • Underlying pre-tax profit: £101.8m (+58.1%)
  • Underlying free cash generation: £162.3m (+135.2%)
  • Net debt: £254.4m (-49.7% – i.e. borrowings have halved)

The general narrative from the firm is similar to previous statements, with the “continued elevation strategy” being a major theme, as are continued problems at House of Fraser.

Looking beneath the figures, the company admits that much of the improvement is as a result of acquisitions. Stripping out acquisitions and currency effects, revenue fell by 6.4% during H1. I suspect this is linked to the performance of the core UK sports retail business, where underlying EBITDA fell by 5.3% to £139.9m. This remains the bedrock of the group — as this segmental view shows, very little profit is generated elsewhere:

Sports Direct segmental EBITDA 1H20

A second point is that the reported pre-tax profit figure includes a one-off £84.9m gain from the sale and leaseback of the company’s Shirebrook distribution centre. Underlying PBT excludes this, so in this case I think it’s a better measure of trading performance.

My view

Although Sports Direct shares have looked cheap at times recently, I’ve stayed away for two reasons.

Firstly, owning the stock is effectively a bet on Mike Ashley’s judgement and his ability to make money from department stores. I don’t think I’m in a position to take an informed view on this.

Secondly, this company has never paid a dividend. For me, that doesn’t appeal. As an income investor, I want yield. I also believe that dividend payments provide useful evidence of cash generation and management discipline.

Despite today’s strong results, my view on Sports Direct hasn’t really changed. I may be missing an opportunity, but I’m happy to stay on the sidelines here.

Chemring (CHG)

  • Share price: 200p (+1%)
  • Market cap: £563m

Full-year results

I’ve run out of time to look at the latest accounts from this defence contractor. But the headline numbers show decent growth and suggest to me that the firm’s turnaround remains on track.

Revenue is up by 13% to £335m, while underlying operating profit is 42% higher, at £44m. Net debt is down to 1.2x EBITDA and full-year expectations are unchanged.

From what I can see, the good news is already reflected in Chemring’s valuation. At current levels, I don’t see any overwhelming reason to invest in this business, which has suffered a string of problems in recent years. But for holders, my view would be that today’s figures are broadly reassuring.

That’s all I’ve got time for today, thanks for reading.


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