Cineplex (OTCPK:CPXGF) still looks to be in a liquidity crunch over the next year despite the company’s recent issuance of convertible debentures to shore up its finances. This is reflected in its share price which, unlike the S&P 500 index that is reaching new highs, Cineplex sits 73% lower year-to-date. The good news it that the Canadian movie theater giant is opening its entire chain of complexes across the country. This network includes 164 theaters, 1,687 screens and 10 entertainment complexes. The bad news is that incremental gross profits from reopening the theater might only be able to slow the liquidity crunch.
While the amount of customer turnout in the coming months, and even years, is still uncertain, the long-term earnings potential and valuation of the business is more clear. Prior to the COVID-19 pandemic, British theater chain, Cineworld, wanted to purchase Cineplex for $CAD 34.0 per share. With Cineplex’s shares currently trading at $CAD 8.89 per share ($USD 6.72) this makes that old acquisition price a 282% premium to the current valuation. Unfortunately, shareholders stand to be diluted by 45.8% if all the convertible debentures recently issued to shore up liquidity are eventually converted at their $CAD 10.94 per share conversion price. As such, these new convertible debentures would lower this old synergistic valuation price from Cineworld to $CAD 23.32 per share (although I doubt the acquisition will return in the next few years as the industry struggles to recover globally).
A Nicely Profitable Company at Its Peak
As Canada’s largest theater operator, Cineplex has been able to achieve a high level of profitability. Since 2010, and excluding the trailing-twelve-month figure ended June 2020 which includes COVID-19, the company has achieved average return on equity (ROE) and return on invested capital (ROIC) of 11.1% and 9.0%, respectively. This level of profitability is slightly below my rule of thumb of 15% ROE but right around the more important 9% ROIC figure allowing me to be confident that, in my opinion, the company would be able to maintain its intrinsic value in a pre-COVID world. However, the high operating costs and interest expenses of the business (including leases), make me hesitant to invest in the business before an idea of customer demand can be gathered.
Source data from Morningstar
How does the Liquidity Look?
Cineplex’s interest coverage ratio was starting to worsen before the COVID-19 pandemic falling from a high of 13.17x in 2012 all the way down to 1.57x in 2019. As can be seen in the graph below, the company clearly began to pursue a more aggressive capital structure over the past decade with debt rising from a low of $CAD 171M in 2012 to $CAD 594M in 2018. In 2019, the debt numbers were affected when accounting standard IFRS 16 – Leases took effect and the company had to capitalize all its leases showing the true leverage of the rent reliant business model.
This aggressive capital structure did not set Cineplex up well to enter the unexpected COVID-19 pandemic. The company has had to obtain relief from leases and certain financial covenants under their credit facilities while they worked to securing additional financing. Just prior to the June 2020 quarter end, Cineplex secured additional financing in the form of $CAD 316M worth of convertible unsecured subordinated debentures with a 5.75% interest rate and $CAD 10.94 per share conversion price.
Source data from Morningstar
To satisfy the lenders of the credit facility who graciously waived debt covenants, $CAD 100M of the new convertible debt proceeds need to be used to repay the outstanding credit facility. With a conversion of 91.4077 shares per $CAD 1000 principle of the convertibles debentures, the new issuance of debt also means around 28.8 million shares could be issued given $316M were issued. This 28.8 million shares represents a significant 45.8% of the 63 millions shares outstanding in 2019.
Is it Enough to Stay Afloat?
To find out what all this financial leverage and new liquidity means to Cineplex, let’s look at an analysis of how long the current cash and new liquidity can maintain operating and interest expenses. The analysis in the table below is based on the latest quarter’s monthly interest expenses, net new implied borrowings at the 5.75% rate, and the latest quarter’ monthly operating expenses (which unlike cost of goods sold are rather fixed overhead that must be spent regardless of the level of sales).
For a second opinion, the analysis also includes a cash based scenario based on Q2 2020 figures provided in the earnings release in which the company stated “net cash burn was $53.9 million for the three months or approximately $18.0 million monthly”.
However, this more optimistic cash figure from management seems a bit biased as the press release mentioned it was based off ‘EBITDAaL’ and as such added back interest expenses and lease payments which have only been waived temporarily. In the Q2 earnings release, management also mentioned they were able to negotiate rent relief with landlords which resulted in no material cash rent being paid in the second quarter of 2020 with some lease agreements converting fixed components of rent to variable rent during the reopening period. While this is a benefit while operations are closed, the new variable rent arrangements will take a bite out of incremental cash flows as theaters reopen.
Opening Theaters… but High Operating Leverage
With COGS being on average 35.3% of revenues over the past 5 years, the cash is not exactly going to start flowing to the bottom line when Cineplex reopens the doors. Over the past 3 years, the average monthly gross margin was $CAD 87.9M. This implies that to cover fixed operating and interest expenses of $CAD 49.0M as seen in the first scenario above, customer demand would need to be approximately 55.7% of pre-COVID amounts. With the choice of at -home and on-demand products from Netflix, Amazon Prime, Disney and the like, I don’t see consumers braving a trip to the movies theater too soon. Right now, the decision of whether or not to go to the dentist is the more pressing dilemma for most of my friends.
While the brand of Cineplex is powerful in Canada, it only means something to equity holders if creditors do not force the company into bankruptcy or dilution continues to occur. The 45.8% dilution already seen with July’s convertible debt issuance might be indicative of what is to happen again if customers aren’t quick to return. For those investors wishing to speculate and buys shares, they might also want to consider braving the trip to go out to the movies sooner rather than later to help the company reach that break-even point of operations.
If you enjoyed this article and would like to read more of my work, click the “Follow” button at the top of the page to receive notifications when I post a new article!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: While the information and data presented in my articles are obtained from company documents and/or sources believed to be reliable, they have not been independently verified. The material is intended only as general information for your convenience, and should not in any way be construed as investment advice. I advise readers to conduct their own independent research to build their own independent opinions and/or consult a qualified investment advisor before making any investment decisions. I explicitly disclaim any liability that may arise from investment decisions you make based on my articles.