The Thesis
AMC Entertainment (NYSE:AMC) is one of the most vulnerable stocks to a second wave of COVID-19. I don't expect a complete societal lockdown to reoccur, but invariably, cinemas will one of the first venues to close.
Given the company's high debt load and precarious liquidity position, in such an event, bankruptcy is the most likely outcome. I don't believe a white knight will appear either unless it is to sift through the rubble.
Having said that, the bull case is intact if the great economy reopening succeeds.
In my view, shorting AMC is an effective hedge to your portfolio if you fear the second wave downside.
Binary Options
In my previous article on AMC, I highlighted four binary options and set out my view on the probabilities of each occurring. My conclusion was that the most likely outcome was an acquisition, followed by a surgical restructure of AMC's capital structure. I suggested that the probability of an acquisition increases as it becomes more and more apparent that bankruptcy is unlikely. Otherwise, it would make sense for potential suitors to wait it out and pick through the rubble.
AMC managed to raise $500 million of liquidity in a private note recently - buying the company some breathing time to remain a going concern until it is able to generate some revenue as it begins to reopen cinemas in June and July.
If AMC is able to successfully execute on the reopening, I expect it to be bought out, simply because the capital structure badly and urgently needs a makeover. It is now saddled with expensive debt, and adjusted EBITDA may not be sufficient to deleverage quickly enough to make a difference. So, there is a clear arbitrage opportunity there for an acquirer with deep pockets to purchase AMC at below replacement cost, especially if other synergies exist (think Amazon (AMZN)).
However, if reopening of the economy does not go as well as expected, cinemas will likely be one of the first venues to be served with a closure notice.
Such a scenario will place AMC in an extremely precarious situation with zero revenue (again!), immense debt load and fixed costs outlays. Given its current liquidity position, the likely path is bankruptcy and shareholders could be completely wiped out. I don't believe the Dalian Wanda Group (AMC's biggest shareholders) will come to the rescue either - it would potentially mean throwing good money after bad money, and Wanda's Chinese masters are clearly not in the mood in the current environment.
In my view, this is largely a binary situation, and I can completely rationalise both the short and long positions.
Q1 Review
Since my last article, AMC published its preliminary Q1'2020. Complete results with full details and investor call are set to come on 9th June. The numbers speak to precarious situation the company found itself in, especially given the COVID-19 impact only materially played in the numbers during March.
Revenue declined to $941.5 million compared to $1,200.4 million a year ago. Adjusted EBITDA reduced to a mere $3.1 million compared with $108.2 million in the previous year. Not surprising at all given the fixed-cost structure of the business.
The most worrying part was the Free Cash Flow (FCF) decline of $275 million compared to a decline of $113 million a year before.
The liquidity position as of 30th April was not any better with total cash resources of $718 million, but the cash balance is attributable to various revolving credits and the $500 million recent private notes. It must be substantially lower by the end of this quarter.
We don't really have to wait for the earnings call - it is very clear that AMC desperately needs cash to come in the door as soon as possible, and there's little margin of safety in the reopening plans.
Green shoots in Europe?
The first cinemas reopened in Oslo, Norway, on the 3rd of June with enhanced cleaning and sanitation protocols. The three Odeon Cinemas already opened will be followed by additional six in Norway in mid-June as part of the first phase of wider reopening in Europe.
The U.S. openings are currently planned for July.
Europe is about a month ahead in the COVID-19 journey, and the soft reopening there will no doubt provide useful lessons and experiences that can be leveraged in the U.S., such as effective social distancing and sanitising protocols. Importantly, it will give some insights about clients' behavioural aspects - is there pent-up demand for live entertainment, or do people still prefer to be cooped up in their home watching Netflix?
Bottom line
I have been bullish on AMC recently, and it has paid off to date.
But looking at the cash burn rate and precarious liquidity position was somewhat of a reality check. I recognise that the risks of a bankruptcy are still heightened. I emphasise this is not a remote possibility. In a second-wave scenario, cinemas will be one of the first venues to close even before retail shops and restaurants. Clearly, AMC does not have the financial resources to ride it out, and even the upside is somewhat capped given it is already burdened by a heavy debt load. I cannot see Mr. Adam Aron, current AMC CEO, being able to pull any more rabbits out of the hat. Even if it did manage to secure some additional funding - someday it needs to be paid back, right? More debt is not a sustainable proposition either.
Given where we are today, I still think that a buyout has the highest probability, and if it does materialize, it will likely happen sooner rather than later. It is a binary situation - if AMC looks like it is surviving and not heading to bankruptcy, this may just well be the catalyst for a buyer to step up (i.e., fear of missing out). The underlying assets are attractive, and it is the capital structure that chokes the returns (hence the prior deleveraging strategy). I am sure the investment bankers already have a PowerPoint deck on this topic. The right buyer who can afford to restructure the debt structure will create a win-win scenario. Plenty of synergies for the right party as well.
So, how do I trade it?
I intend to sell some of the profits and may consider taking a short position in AMC. I do not necessarily see it as a single-name hedge, but rather as broader portfolio hedge, should a second wave of COVID-19 materialise.
It would be great to obtain others' ideas, challenges and inputs in the comments section to assist in stress-testing my thesis.
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