J. Michael Jones
For some time now, it has been my conviction that the theater business has bigger problems than COVID-19 or even streaming. Its biggest problem is a fundamentally asymmetrical relationship with its studio partners which makes it almost impossible to create a long-term profit stream.
On this basis, I have been bearish on AMC Entertainment (NYSE:AMC) and Cineworld (OTCPK:CNNWF) and no more than neutral on Cinemark (CNK) though I consider that the strongest of the three right now.
With the announcement that Cineworld will almost certainly file for bankruptcy in the next few days, some are considering it a boost to AMC because the elimination of a competitor will boost its own prospects. I disagree with this and maintain my sell recommendation for two reasons: first, I’m not sure a competitor is actually being eliminated. Second, even if it is, the benefits of a smaller, leaner, more efficient theater industry will probably not accrue to AMC.
Cineworld Bankruptcy
It is important to understand that while all theaters are struggling in the wake of the pandemic, Cineworld’s bankruptcy doesn’t really indicate that they are struggling any more than most, at least in an operational sense. Cineworld – operating under the Regal Theaters banner in the US – isn’t really bleeding any more cash than AMC is. On a per-dollar of revenue basis, they reported almost the exact same loss as AMC in 2021.
Not surprising, considering there’s basically no real difference between them now. Regal, like AMC, has been experimenting with charging higher prices on tickets to more in-demand films – read, Marvel/DC blockbusters – to raise overall revenue levels without hurting the smaller films that are already treading water. Regal, like AMC, has a severely overpriced and rather ineffective subscription option.
When there is a disparity, it almost favors Regal. In late 2020, when a lull in COVID-19 ended with a renewed wave, Regal shut down all of its theaters a second time, while AMC decided to hang tough, hoping that the closure of so many competitor locations would help it ride out the second wave of COVID. Considering how long that wave lasted and the low late-’20/early-’21 revenues were in theaters, Regal was if anything perhaps a better steward of shareholder capital for those weeks they were closed.
Rather, the proximate cause of Cineworld’s impending bankruptcy is the judicial judgement of almost $1 billion in Canada for the aborted acquisition of Cineplex which Cineworld tried to walk away from when COVID-19 derailed the movie industry. They’ve been found in default of the agreement, which doesn’t really have a “pandemic escape clause.”
Bankruptcy Industry Impact
In other words, while Regal probably does suffer from a structural inefficiency, it’s the same inefficiency its competitors suffer from. There is nothing inherently less efficient about Regal compared to AMC or Cinemark. This is an industry-wide problem.
This is why the bankruptcy may not help AMC much. Since Regal theaters are just as (in)efficient as AMC’s, the bankruptcy court might very well leave them to continue to operate, while conducting a debt-to-equity conversion to secure the capital needed to pay off the judgement and other expenses.
There’s no way to know that, of course, and I don’t dismiss the possibility of a trimming of the theater fleet or perhaps even a wholesale liquidation. In any oversupplied industry, a bankruptcy can be a perfect opportunity to trim costs by closing locations, walking away from leases, and otherwise getting a jump start on cutting costs that might otherwise be locked in for the next few years. Even if Regal is just as good as AMC, if one of them has to go to balance an oversupplied industry, perhaps the bankruptcy is the tiebreaker that decides which?
I’m not entirely convinced, but let’s assume that’s true. I’m still not sure AMC is the winner in that scenario.
AMC’s Fundamental Problem: Asymmetry
As I’ve described before, the current economic system of movie theaters is not exactly a balanced relationship. Essentially, the current theater system is a subsidy engine for Disney (DIS) and, perhaps, Warner Bros. (WBD) to extract revenue and profit at the expense of other studios and their theater partners. This is because the high fixed-cost nature of movie theaters combined with the pay-per-view nature of movie tickets means that most consumers today are only buying tickets to recognizable IP which they are almost sure to enjoy. This gives all leverage in negotiations to those owners of major franchises such as Marvel, DC, Lucasfilm, Pixar, and Disney Animation. As you’ll have noticed, all but one of those fall under Disney’s umbrella.
This is why even before COVID-19 hit, AMC and Regal were on a combined basis consistently reporting no profit in the five years before COVID hit. They never reported sustained losses, either. They just kept paying their bills and going home empty-handed, as studios – principally Disney, with some crumbs for the others – kept taking home the cash.
The reason for these constant zero-profit numbers in the first place is that studios enjoy a variety of methods to calibrate their “take rate” to match the projected revenues minus costs of films. That is, if movies in a given year are going to generate $18 billion in ticket and concession revenue, theaters know to charge $6 billion in fees to rent their films, since they know the theaters have $12 billion in largely fixed costs. When theater revenues decline to $15 billion, studios might only charge $3 billion in fees. If they rise to $20 billion, they’ll charge $8 billion in fees.
If suddenly, a significant portion of Regal theaters did disappear, sufficient say to drop theater costs to $10 billion per year, theaters would certainly know a significant cost cut was coming… but studios would know it as well. The real issue for theaters, then, is not that they have too much fixed costs; that is a mere symptom of the problem. The cause of the problem is that theaters lack any leverage in negotiations with studios to prevent them from upping their take rate and essentially hogging the cost savings of a Regal bankruptcy – or for that matter any other source of cost savings – for themselves.
If a bankruptcy does take some amount of costs permanently out of the system, I think we are more likely to see studio profits go up than AMC’s or Cinemark’s.
An End Run Around Shareholders
While all this is going on, AMC shareholders are beset by another major issue: a disguised dilution is coming for them. Or at least, for their Class A common shares. Officially, it’s being called a stock split. But wait. This is not a stock split in the traditional sense. It’s something different and, for common stockholders, something far worse.
AMC can’t do a traditional stock split since last year shareholders blocked a plan to increase the number of authorized shares, which now stands at barely 1% more than currently issued shares.
What AMC is doing is issuing new preferred equity shares to its current shareholders, on a 1-1 ratio. Every common share is getting a preferred share – actually a depository share of 1/100th of a preferred share, which in turn is convertible into 100 shares of AMC’s Class A stock. These preferred shares will actually have full voting rights with current shares, very unusual for preferred equity.
The key point is this. The company is issuing approximately 516 million preferred shares. But it is authorized to issue 5 billion preferred shares. In getting the ball rolling on the preferred stock by issuing it to current holders of the common stock, AMC has in fact effectively dissolved the limitation on its common share issuance and paved the way for further dilution of existing shareholders through subsequent capital raises. Which it has already admitted it fully intends to do.
That’s bad enough if every current shareholder simply holds their preferred shares and watches the company dilute them to roughly 10% of their current value. It’s even worse, however, for future investors buying into the now second-class common stock after the preferred issuance happens. The current Class A stock, trading with the AMC stock symbol, is about to become worth less than ever because soon there will be a preferred equity with equal voting rights trading ahead of it in the liquidation preference; which is to say, behind it in the bankruptcy firing line, if it comes to that.
Class A Is Now Last-Class
There is one final demerit to Class A common stock now: these preferred shares are convertible to common stock. This means that unlike ordinary preferred equity, common stockholders don’t even have a superior upside to the preferred equity. If things do by some miracle go well for AMC, preferred equity will simply convert to capture any additional upside to the stock. If things go poorly, as seems more likely, they will not convert and, as I said, they will get the cover of the common shares ahead of them in any reorganization.
Between the voting rights and the conversion rights, this is little more than a runaround of the limits that AMC shareholders put in place on dilution. These preferred shares are superior to common equity in every way, and anyone buying them is going to treat them like common equity, with the current common stock assuming the characteristics more of warrants, offering what will probably in the end amount to no more than a 9% share of the future company if everything goes well.
Which it probably won’t. The most likely outcome of this is when AMC either files or reorganizes outside of bankruptcy, the superior position of the preferred equity will see the preferred shares emerging with near-total control of the new equity and only a token shareholding, if that, for the current Class A shareholders.
Debt Retirement Possibilities…And Limits
The one possible upside of the future issuance is that it may offer an opportunity to eliminate AMC’s debt load. At roughly $5.1 billion, assuming a $20 price for each preferred share AMC could eliminate its entire debt with an issuance of roughly 50% of the current float. That would put the current common shareholders at roughly a 40% ownership stake of the company. Meanwhile, the elimination of the $387 million in interest expense the company paid last year would produce roughly $6 per share in value, at a 20 P/E ratio. Of course, that would be contingent on the company first eliminating its $1.05 billion loss from 2021.
Investment Summary
It is not clear if any significant number of Regal theaters are going to be closing in the first place. Even assuming they are, AMC and peers like Cinemark cannot reasonably hope for that to generate a significant benefit to their shareholders until they secure some source of leverage in negotiations over studios.
Meanwhile, the coming dilution of AMC shareholders means that the common stock is about to be placed junior to another company equity with full and equal voting and dividend rights to it, but ahead of it in the liquidation order of priority. Needless to say, that is not a development to encourage a further rise in the stock. But the meme crowd has been irrational before.
While it is almost impossible to ever say that a meme stock won’t rise, I do not consider recent developments bullish for AMC as a company. I consider them positively deleterious for Class A stock of AMC, so I am maintaining my Sell recommendation.
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