AMC Entertainment (NYSE:AMC) has made three substantial acquisitions in the past year that are now going bad. The company has leveraged up significantly and this is very painful amid secular headwinds, along with the impact of few blockbusters and warm weather.
The second quarter appears very poor given the big profit warning, as I see risks to the full-year guidance. This is worrying amid the debt load and poor cash flow conversion. For these reasons, I am not automatically buying the dip, even as shares are down 50% from levels seen in April. For now, I maintain a neutral stance on the business, while following the developments with great interest.
AMC now has operations in 15 countries, in a business that encompasses 1,000 theaters and more than 11,000 screens. The company is the leading operator in most of the countries in which it operates, as its theaters draw 385 million visitors each year on a pro-forma basis. The business was originally heavily focused in the U.S., and acquisitions in Europe mean that roughly 30% of the theaters and screens are located in Europe -- although the average size of each theater on the "old" continent is typically a bit smaller.
While many have predicted difficult times for the movies business amid the "stay at home" economy and emergence of services like Netflix, the business has held up reasonably well, at least until now. The resilient performance in recent years can be explained by the fact that this kind of entertainment comes at a very competitive cost compared to other alternatives, such as dinner, theme parks, entertainment parts, concerts or sport events.
To differentiate itself from its peers, the company is investing heavily in its differentiation factors. This relates to comfortable chairs, enlarged food offerings, premium sight and sound, loyalty programs, targeted programming, and acquisitions.
The latter part is what AMC has certainly done, on top of rolling out IMAX screens and boosting food revenues. In 2016, Carmike Cinemas was acquired in a $1.1 billion deal that added over 2,900 screens. The purchase of Odeon in Europe added over 2,200 screens at a cost of $1.2 billion. The purchase of Nordic Cinema Group adds nearly another 700 screens at a cost of another $1 billion, doubling the pro-forma size of the business compared to the legacy business.
In the June investor presentation, AMC reported pro-forma revenues of $4.92 billion per annum as well as adjusted EBITDA of $842 million. Note that this pro-forma number is only based on the deal with Carmike and Odeon, as the purchase of Nordic and synergies from the other two deals are not included yet. These synergies were seen at a combined $50 million for all the three acquisitions.
The purchase of Nordic, announced earlier this year, adds roughly $350 million in sales for a pro-forma revenue number of close to $5.3 billion. As the EBITDA contribution of Nordic was not announced, I peg the contribution at $60 million, assuming that margins are similar as reported by AMC. That results in a pro-forma EBITDA number of $950 million following the consummation of all the three deals and realization of synergies.
Not only has the movies business been cooling down, investors have backed away from the aggressive acquisition-driven strategy inspired by Wanda. Shares of AMC still traded in the low $30s by late April, but ever since it has all gone downhill.
In early May, AMC posted its first-quarter results as shares were still trading in the high $20s, and the quarter marked a "tremendous start" to the year according to CEO Adam Aron. The dealmaking spree of 2016 and in early 2017 saddled the business with a net debt load of $4.6 billion, however, as equity investors witnessed 25% dilution on top of that. The 121 million shares traded at $29, for a an equity valuation of $3.5 billion and an enterprise valuation of $8.1 billion. The modest equity valuation highlights how aggressive the company has been. The three deals announced over the past 18 months have a value being equivalent to roughly the equity valuation back in April.
There had not been many real corporate news events since then, until the end of July when the company issued a press release to speak out against erroneous information regarding the business following speculation in the media. This related to Dalian Wanda, which is the majority owner of AMC. The company stressed that Dalian Wanda has never funded AMC in terms of deals being made, nor have Chinese banks provided funding in connection with these deals, as intercompany dealings between AMC and Wanda are very limited.
Nonetheless, shares have drifted lower to the low $20s on the back of concerns related to Wanda and worries about the business and the warm weather, amid few box office hits. This is now confirmed in the results, as the company is warning about second-quarter earnings after a "great" first quarter. The company is posting a big loss thanks to the investment in listed firm National CineMedia LLC, but that is not the real shocker.
The North American box office saw declines of 3.3% in the second quarter, as revenues were down by 4.4% in the U.S. This could not be offset by a double-digit increase in European sales, and unfortunately this is a much smaller business in a seasonally weaker quarter. All of this has serious repercussions for the business. Adjusted EBITDA is expected to rise from $130 million in Q2 2016 to just $135 million, plus or minus a million in the second quarter of this year. As no quick recovery is seen in Q3, the company is taking steps to adjust its cost structure.
The final results will only be published next week, but for sure it will be ugly. The company expects full-year adjusted EBITDA at $860-$900 million, which at the midpoint represents a $65 million miss vs. consensus expectations. Note that the projected second-quarter EBITDA guidance already missed expectations by an almost similar amount, which creates real downside risks to the full-year guidance in my opinion.
Note that adjusted EBITDA totaled $251 million in Q1 of this year, when the Nordic deal still had to close. This deal closed on March 28, which essentially means that there was zero contribution in Q1. The first-quarter adjusted EBITDA number was over $100 million ahead compared to the year before, as the second-quarter EBITDA advancement is limited to just $5 million.
As a result, the pro-forma EBITDA number of $950 million should no longer be relied upon. In fact, I believe that there are downside risks to the revised adjusted EBITDA guidance of $860-$900 million as communicated by the company. I think a number around $750 million might be more realistic now.
That is a big issue. If we assume that D&A charges run around 8% of sales, and those sales now come in at just $5 billion a year, I peg D&A charges at $400 million. That leaves operating earnings of merely $350 million, but note that gross debt stands at a very elevated level as the interest bill alone amounts to $250 million a year. That leaves pre-tax profits of merely $100 million, or close to $70 million after tax. That comes in at just $0.50-$0.60 per share, as the reduction in earnings capacity pushes up leverage ratios to over 6 times EBITDA. Even worse, the quarterly dividend payout of $0.20 per share implies that the company is not deleveraging at all, as it is paying out more than its anticipated earnings in the form of dividends.
Shares have fallen by 25% in response to the news, now trading at just half of the levels at which shares traded in late April. The $15 move in the stock wiped out roughly $1.8 billion in shareholder value, which is very substantial in relation to the dealmaking spree of last year.
I hate shorting late in the game, and while AMC looks to become quite challenged just months after the latest deal closed (after a mini roll-up story has gone bad), I am not going to overreact. After all, the industry is impacted heavily by film titles and seasonal weather issues.
The reality remains that the company remains is highly challenged, especially as many consumers appear to opt to watch movies from the comfort of their home. Even while movies provide reasonably priced entertainment, the actual entertainment is not that spectacular and long-lasting, while the bill is still reasonable if you count in the premium options and food offerings.
As indicated before, I see very modest earnings power and very high leverage, while working with a $750 million adjusted EBITDA number for the year. If we blindly trust management and use the $880 million EBITDA midpoint of the guidance, and take into account a combined $650 million interest and depreciation bill, pre-tax profits are seen around $230 million. With a 30% tax rate, a $160 million earnings number translates into earnings of $1.25 per share.
While a 12 times multiple looks reasonable, the prospects are rough and leverage is very high. Prospects for deleveraging are not very good given the $0.80 per share dividend payout and the fact that depreciation charges trail expected net capital spending of $500-$550 million by some $100-$150 million a year.
This does not make me an automatic buyer of the dip, although AMC remains a dangerous short at the reduced valuation as well. I am very interested to hear more commentary from management next week.
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