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$APE is for Accretion
#15: The AMC / APE split is a financial and strategic no-brainer. AMC shareholders should welcome it.
AMC Entertainment Holdings Inc. (NYSE: AMC) is the largest movie theater operator in the world and perhaps the most polarizing stock in the market.
AMC’s supporters are rabid and unshakable in their allegiance. They believe in the company and its management implicitly1. They assume that critics are short-sellers or Wall Street crooks intent on destroying the company for financial gain.
Meanwhile, AMC’s critics see the company as a financial abomination and posterchild for market absurdity. They believe the business is doomed and its management are crooks intent on swindling naïve shareholders. They assume the rabid retail base is some combination of ignorant and stupid.
I’m not interested in either team. But, I’m fascinated by AMC as a matter of corporate finance.
Last week, as it announced second quarter earnings, CEO Adam Aron revealed a unique corporate action that he claimed would transform the company.
The company announced special dividend of one new preferred equity unit for each share of AMC common stock, which will trade under the symbol $APE. Essentially, AMC announced a stock-split which creates a dual-class of equity in the process. The $APE units are functionally identical to $AMC shares and since they will be distributed pro rata to the existing AMC shareholders, this dividend has no direct economic impact. There will be twice as many shares outstanding, and each holder will have twice as many shares.
Yet despite the dividend having no direct impact on value, Aron didn’t hold back in declaring the importance for the company and its shareholders - to quote directly:
“This is a major step forward for AMC. In my view, probably the biggest favorable development for our company in all of calendar year '22, both looking back and looking ahead. Looking at the long-term future of our company. We believe this is truly great news for AMC and not such good news for those prophets of doom, who may be rooting against us.”
I couldn’t agree more.
Let me explain…
First, consider the company’s capital structure today.
As of August 10th, AMC is a $16.4 billion company. That valuation includes $12.2 billion of equity value, $5.1 billion of debt and just under a billion dollars of cash on hand.
This cap table has some peculiarities. The company has nearly $5 billion of expensive secured debt - suggesting it is a risky credit - and yet nearly 75% of its valuation comes from its common equity, meaning that shareholders believe the company is worth much more than its debt.
Looking at implied valuation and credit metrics, the divide between debt and equity grows more stark.
AMC is trading at over 62x its estimated 2022 EBITDA of $262 million. Compared to its estimated 2024 EBITDA - which is roughly in line with its pre-COVID levels - the company trades at 25x EBITDA. Even with a full rebound in its business over the coming years, the company is expected to generate losses (negative net income) to its shareholders.
Valuations of 25x - 60x EBITDA are usually reserved for asset-light tech companies with explosive growth, not mature asset-intensive businesses like AMC. For reference, in the decade prior to COVID, AMC traded at ~7x - 14x EBITDA. I’m not making a judgement of what the proper multiple for AMC should be, merely stating what the market implies today. Today the equity trades at a high multiple by historical and absolute standards and therefore is a cheap source of financing for the company.
Yet while the total valuation looks rich, the credit metrics are a disaster.
AMC is nearly 16x (!) levered on a net debt / 2022 EBITDA basis. The anticipated growth in EBITDA in the coming years would bring down leverage to 6.4x by 2024, but 6.4x leverage is still enormous by any standard. S&P rates the company with triple hooks (CCC+).
Interest coverage metrics suggest a tough path along the way. Using EBITDA less capex as a proxy for cash flow available to service debt, the company will not be able to cover its interest expense from internally generated cash flows until at least 2024. Instead, it will need to draw on its existing liquidity, including its $965 of cash on hand and $211 million of undrawn revolver capacity to continue to service debt as the business recovers. Beyond interest, the company has debt maturing in 2023, 2024, 2025 and 2026 that will need to be refinanced.
With over a billion dollars of available liquidity, AMC is not an imminent bankruptcy risk, but the challenge of managing this debt load will be a massive overhang for the coming decade. If the business does not perform as expected or if refinancing proves problematic, there is a real chance of bankruptcy in the coming years absent fresh capital.
This is what makes the situation so interesting. AMC is both an equity darling and a distressed credit.
From the company’s perspective, its debt is very expensive and its equity is very cheap.
According to your finance professor, this shouldn’t happen. Financial theory says debt should be cheaper than equity, because equity holders take on more risk and are subordinated to the debt2.
AMC proves your finance professor wrong, and we know why. AMC’s debtholders are institutional credit investors concerned with downside risk, who see negative cashflow, massive leverage, and a long and uncertain return to profitability. Equity holders are different. They are largely individual investors who believe in the business and its management (or perhaps are simply trying to make money on the price volatility and are altogether indifferent to valuation).
As a result, the typical math of corporate finance is flipped on its head.
Consider a typical share buyback. Normally, a company looks to issue cheap debt to buy back expensive shares, generating value to shareholders in the process. AMC, however needs to do the reverse. By issuing cheap shares to buy back its expensive debt, it can generate value to shareholders.
But there’s just one minor problem. AMC cannot issue any more equity - it has already maxed out its authorized number of AMC common shares. Enter the APEs…
The initial distribution of APEs to the common AMC shareholders has no economic impact. It is just a stock split that creates a new class of equity. But it is transformative because it allows the company to issue more equity in the future. Here is where things get contentious.
Critics were quick to point out the APE split was merely a way to get around the common share authorization limit and issue more equity. This is precisely the point.
Far from “hiding the ball”, management has been upfront about their intention to raise additional equity via APEs.
It was previewed, at the Annual Shareholder meeting on June 16:
“However, for full transparency, I have previously said publicly that a decade ago, the Board of Directors of the company authorized the creation of preferred stock at AMC, but that's a different kettle of fish and we would only consider creating preferred stock if we were convinced it was in the interest of AMC shareholders to do so.”
It was stated explicitly in the 2Q announcement on August 4th:
“This new AMC preferred equity provides AMC with a currency that can be used in the future to further strengthen our balance sheet, including by paying down some of our debt and other liabilities”
And again from @CEOAdam on Twitter that same day:
In fact, Aron used the term “currency” six times during in the 2Q earnings call to describe the APEs. Nobody is trying to pull wool over the shareholders’ eyes, and shareholders are free to sell if they are worried about dilution.
Despite the finger wagging, it seems shareholders on balance they very comfortable - AMCs common stock is up 30% since August 3rd. And they should be. Issuance of APEs will be accretive3.
To rebut the claim that issuance of APEs would be detrimental to common shareholders, Aron sent the following tweet:
Aron is correct, but his explanation could have been more precisely worded. The problem is semantics.
When a company issues more shares4, the existing owners will hold a smaller percent of the total equity class - this is what Aron means when he says “dilution”.
Yet, when we use the term accretion or dilution in practice, what we really mean is whether it is accretive or dilutive to shareholder value, not merely whether there are greater or fewer shares outstanding. Issuing shares can be accretive, depending on how the proceeds are used.
Consider an all-stock merger.
If a company which trades at a 20x P/E buys a target that trades at a 10x P/E (i.e. a relatively cheaper company) in an all stock merger, it is accretive to shareholders. There are more shares outstanding and so each holds a smaller percent of the total pie, but the size of the pie grew by more than the share count - its value accretive5.
The same applies for transactions within a single company’s capital structure.
Since AMC’s equity today is much cheaper than its debt, we don’t even need to run numbers to know that issuing equity to repay debt would be accretive6, but let’s do it anyway.
Hypothetically, let’s assume that AMC were able to issue $5.1 billion of new equity at current market prices to repay all of its debt. (For simplicity, ignore the authorization limitation and assume AMC could continue to issue common shares).
To repay $5.1 billion, the company have to issue 261 million new shares at $23.67 per share, bringing the total shares outstanding to 732.9 million.
The issuance would increase the common share count significantly. Existing shareholders would only own 70.5% of the common share class (down from 100%), but in the process, remove $5.1bn of debt that sits in front of them in the capital structure.
Now let’s look at the impact to cash flow7.
Repaying the debt eliminates $341 million in annual interest expense, freeing up that cash for shareholders. Despite the 261 million additional shares, the cash flow available to equity increases by $0.46 - $0.63 per share. This equitization would be highly accretive on a cash flow basis.
This example is grossly simplified8 and purely hypothetical but demonstrates the point mathematically.
In reality, it understates the benefit.
AMC’s debt burden represents an existential threat to its common shareholders - far and away the biggest challenge to realizing long term value in the stock. Taking out the mountain of expensive secured debt that drains the company’s cash flow and sits in front of the equity is incredibly de-risking to shareholders, and removes the biggest challenge the company faces moving forward.
Financially it is beneficial. Strategically, it is a no-brainer9.
Discourse of AMC tends to fall along tribal lines. Whether you were supportive or dismissive of the APE announcement likely reflects your opinion on “meme stocks”, retail trading, and the wild state of capital markets over the past two years. Unfortunately, this overshadows a counterintuitive case study in corporate finance.
Equity usually is not cheaper than debt. Most distressed credits do not have the luxury of issuing cheap equity - but if they can, they should. It optimizes the capital structure and benefits its creditors and shareholders.
I’m not an APE - I don’t own AMC, and make no attempt to value the company. Nor am I stating an opinion about any other strategic decisions the company has made.
But I do agree with the CEO on this issue. The APE split is necessary, transformative and beneficial for shareholders.
$APE is is for Accretion.
(Don’t agree? Let me know in the comments)
Or perhaps don’t care about either and instead are interested in making money on the stock’s volatility.
If AMC’s cost of debt is ~7%, the equity should price at a premium to that level. As a simplistic metric, AMC should theoretically not trade above a P/E of 14.3x which would equate to a 7% earnings yield (1 / 14.3). Of course, AMC has no earnings today and likely won’t for years to come. In the case of a distressed credit where the asset value is lower than the debt outstanding, the equity should in theory trade based on an option value of the equity upside. Theory and practice are two very different things.
If it repays debt.
To new third parties, as opposed to existing shareholders like in a stock split or the APE dividend.
Alternatively, if the company bought a target at a 30x P/E (a relatively more expensive company), it would be value dilutive.
A TEV/EBITDA ratio of 25 - 60x means the company is being valued at a 1.6% - 4.0% on a cash flow (EBITDA) basis. The average cost of debt is much higher around 6.7%, meaning that the cost equity much be must lower than the 1.6 - 4.0%. The debt is dilutive to equity.
These cash flows are totally illustrative. I’ve just used consensus EBITDA, assumed LTM interest expense, made a simple capex assumption based on pre-COVID trends, and assume no taxes given the company’s massive recent losses.
AMC probably can’t raise that much equity without impacting price, and they probably would not choose to repay all their debt now anyway. Rather they would focus on the highest cost debt, which makes the math even better especially if they can buy it at a discount as they did in 2Q, when they paid down $72 million of face value for just $50 million.
In fact, it’s reminiscent of another equity darling, Tesla. How many people criticized Elon for issuing $10 billion of Tesla in late 2020, to shore up cash and repay debt? In that case, it seemed obvious that shareholders should accept minor dilution in order to improve the company’s liquidity and leverage. The same applies here, except the leverage situation is much more dire.