Investors Continue To Ignore Debt

I don’t like movie theater investing. About 85% of that $11 ticket you buy goes to the content creator for the movie you’re about to watch, and only 15% makes its way to the owners of the theater itself. The entire basis for owning stock in movie theaters is because you are compelled by the concession stand sales. Given that moviegoers encounter ballpark pricing with $4 candy bars and $5 soft drinks at the movies, I don’t see much room to raise concession stand prices without encountering an offsetting steep drop in demand.

This means that growth needs to come from increased foot traffic. I don’t see that happening either, as the proliferation of large in-home TVs and the rise of Netflix have dampened consumers’ appetites for the enjoyment of the theater experience. You can see this in the numbers, as movie foot traffic declined by about 2.5% annually from 1993 through 2005 and has declined at 4% annually from 2005 through 2015. The prices have gone up, and the value of the experience has gone down, causing an intractable problem for industry economics.

For those reasons, I don’t cover movie theater stocks because I have low confidence that even excellent operators can make it work over the long run. And, even if they do, it will be in the face of so much difficulty that an investment delivering commensurate returns can be found elsewhere without taking on this miasma of industry risk.

Which brings me to AMC Entertainment Holdings (AMC), the parent corporation for AMC theatres. I have no idea what people are thinking bidding up the price of the stock to $35 per share right now.

It is only earning $100 million in annual profits, and the $35 stock price values the company at $3.4 billion. That is 34x earnings for a business that hasn’t grown profits over the past three years and tends to experience deep drops in profitability during recessions when those $11 tickets are excised from the family budget.

And the craziest thing is, the balance sheet is in shambles. AMC Theatres is carrying $2 billion in debt. The cash flows, which have trouble growing, are leveraged at a rate of 20:1. This is the perfect recipe for a massive share dilution or worse years down the road, which will inevitably cause people to say things like “The stock market is a casino” or “Everything is rigged in favor of Wall Street.”

No. Resist those bromides. The future harm for AMC shareholders can be anticipated right now. When you have cash flows leveraged at a rate of twenty to one, and those cash flows aren’t growing, and the stock is trading at 34x earnings, and there is no recession artificially deflating the numbers, you should be able to predict poor future returns for those placing an AMC stock buy order at $35 per share today.

In February, this stock was trading at $20 per share. That was a far closer approximation of intrinsic value than the price investors have bid the stock up to nine months later.

Broadly, why do I think this is happening? Because low interest rates permit ignorance of balance sheet analysis. You can get away with ignoring balance sheet debt when interest rates for corporations are 1%, 2%, 3%. At AMC in particular, the company is only required to pay $100 million in interest on its loans. The problem is that the principal will come due in 2022, 2023, 2024, and 2025. At that point, AMC will need to come up with big chunks of cash to pay off that $2 billion debt burden. Of course, it won’t be able to do that, and will need to refinance. My guess is that $100 million interest over the life of the debt will turn into a $350-$500 million debt burden.

That is going to be a problem. Plus, AMC is suffering from what I call the “Barnes & Noble dividend problem” by paying out a large dividend when it shouldn’t. AMC’s dividend policy isn’t as egregious as it is at least supported by profits, but I don’t think corporations that are leveraged 20:1 should be returning 75% of profits to shareholders as dividend. Right now, after discounting the cash that goes toward the dividend, AMC Theatres only has $25 million coming in that can be thrown at the $2 billion debt principal. This is where practicing capitalism as the pursuit of short-term shareholder appeasement rather than the execution of the corporation’s best interests in the long run becomes an act of self sabotage.

The prospects of materially higher interest rates over the next five years are high enough that you should at least steer away from investments that will condemn you to mediocrity if typical corporate borrowing hits 5%. The 2006-2016 decade has enabled investors to form the sloppy habit of overlooking the quality of corporate balance sheets because high debt doesn’t slam you in the face when interest rates are at rock bottom. But if you are looking towards the future, and can foresee higher borrowing rates, you should steer clear of corporations with hyper-leveraged balance sheets.

I say this in the spirit of “word to the wise” and not a preachy way. I’m not immune to making this mistake. I’ve only lost big money on one investment in my life, and it was the purchase of Valeant Pharmaceuticals, a corporation that was leveraged at a rate of 17:1 at the time of my investment and encountered very public impairment to its cash flows. People ignore the fact that if Valeant had a balance sheet like Johnson & Johnson, it would have been able to sail through its crisis with nothing more than a footnote on its Wikipedia page about the scandal.