This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
Penny stocks are shares in companies that trade for less than $5.00 per share. With a current price of $6.67, AMC Entertainment (NYSE: AMC) isn't far from that mark. And while the stock might look like a good deal, it is cheap for a reason. Let's explore why the struggling movie theater operator looks poised for more downside over the long term.
Profitability challenges and weird managerial decisions
We all know the COVID-19 pandemic devastated in-person entertainment venues like movie theaters, which saw their locations closed for much of 2020 and 2021. Now that the industry is back on its feet, sales are soaring -- but profitability has been slower to return. AMC's third-quarter earnings report highlights this challenge. While revenue jumped 162% year over year to $1.17 billion, the company generated a net loss of $121.6 million mainly because its operating expenses outstripped its sales.
But management's questionable decision to purchase a 22% stake in precious metals company Hycroft Mining is also contributing to the problem -- generating a $57.3 million investing expense (a non-cash loss) in the period. It is unclear what relation an asset like Hycroft has to AMC's core movie theater business, and the acquisition showcases a pattern of unorthodox and arguably reckless managerial decision-making at the company. Unfortunately for investors, it doesn't end there.
Alarming levels of equity dilution
Other pandemic losers, such as cruise operator Carnival Corporation undertook vast amounts of long-term debt to survive the crisis. AMC had a different approach: equity dilution. The company raised capital by issuing more of its stock -- a process that increased its shares outstanding from 135,528 in the second quarter of 2019 to 516,821 in the corresponding period of 2022, an increase of 281%.
From a management perspective, this was probably the right move. AMC's stock price has been artificially inflated by the meme stock movement. And the dilution allowed the company to quickly raise cash without undertaking the solvency risk that would have come with debt financing. But there is no such thing as free money. Equity dilution is a problem for investors because it reduces their claim on current and future earnings. This can lower the fundamental value of their shares.
AMC's management also seems to be taking their dilution habit too far.
In April, the company announced a special dividend of preferred shares called AMC Preferred Equity (NYSE: APE) units at a rate of 1 for 1 with the company's common stock outstanding. Management promptly began diluting the new equity by agreeing to sell 425 million of the new shares in September. On the surface, APE may look like a way to sell more shares without diluting the original AMC equity, but there is a catch.
APE shares have full voting rights and can become convertible to AMC common stock if shareholders approve. With the number of APE shares rising quickly, the dilutive chickens could eventually come home to roost.
AMC is cheap for a reason
While AMC's low stock price might catch the attention of bargain-hungry investors, it pays to look before you leap. Even if the company's operational challenges are eventually resolved, management's questionable decision-making and relentless equity dilution are major red flags for long-term investors. Continued declines look likely.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
