On Friday, Puda Coal (AMEX: PUDA) announced that its Chairman Ming Zhao is willing to buy out the shares of PUDA he does not already own at a price of up to $12 per share, provided he can find financing to do so. The offer is nonbinding and preliminary with no financing, timeline or any degree of certainty in place.
This would obviously be an incredibly good deal for PUDA shareholders considering Chinese public records show CITIC purchased 49% of PUDA’s operating subsidiary, Shanxi Coal for only $37.1 million on 7/15/10, which at the time valued PUDA at only $1.91 per share. Another measure of PUDA’s intrinsic value is the book value of PUDA’s investment in Shanxi Coal that is only $3.41 per share. By comparison, $12 per share seems like a great exit. So would $15, $20, or $30 per share, if any of these were achievable. Dream on!
Unfortunately, Chairman Zhao is extremely unlikely to find any way to finance the purchase of the approximately 20.5 publicly held shares. At $12 per share he needs over $246 million to close the deal. Shanxi Coal is already wildly leveraged thanks to Zhao’s secret dealings (documented in my previous article) and owes $530.3 million 14.5% debt to CITIC payable in 3 years.
By my estimates, Shanxi Coal’s 2011 cash flow is insufficient cover the $76.9 million interest and fees payable to CITIC in 2011. If its mines are upgraded successfully and can produce according to plan the $530.3 million debt can possibly be serviced in 2012. Therefore adding another $246 million debt to Shanxi Coal in 2011 is impossible and certainly would not be in the best interests of CITIC. Remember CITIC completely controls the company through its 49% ownership and 51% share pledge, veto and voting rights. Why would CITIC have any interest in adding more debt when the existing debt can hardly be repaid?
So if Zhao can’t use Shanxi Coal as collateral, what other possibilities are there? Furthermore why should anyone trust Zhao after the discovery of his secret dealings in the past (see my previous article) resulted in the plunge in share price and the stock being halted, Zhao's voluntary leave of absence, and a lengthy investigation? Some claim Zhao is rich. Perhaps he would be willing to pledge his other assets (outside of Shanxi Coal) to borrow $246 million to buy PUDA’s publicly held float.
But perhaps he has pledged those assets already. Zhao's other assets might be just as heavily leveraged as Shanxi Coal. I cannot imagine any offshore bank will lend to him after the PUDA fiasco, and keep in mind he needs an offshore bank to lend dollars to buy out U.S. shareholders. He is certainly aware the $12 (maximum) offering price is over 6X the $1.91 valuation CITIC paid in 2010. He also knows $12 is the price at which PUDA sold 7.85 million shares in its most recent public offering.
So Zhao’s “up to $12” offer is really his way of saying “I will try to make the most recent PUDA investors whole on their investment, eventually, if I can. Trust me.” Zhao is trying to be a politician, in other words. Do you trust him? When he sold half of Shanxi Coal to CITIC, without disclosing the sales to investors, where did the $37 million in proceeds go? At the very least the missing $37 million needs to be accounted for by the Board before Zhao's $12 offer can be taken seriously.
Sometime in 2012, if Shanxi Coal is performing well enough (something only Zhao will truly know), then he might then be willing mortgage his other assets (assuming they aren’t already mortgaged) to fund a $12 takeout. On the other hand if Shanxi Coal is not servicing its huge debt then CITIC will take the 51% pledged shares and Zhao and U.S. investors are left with nothing. Again, I must emphasize that only Zhao truly knows how Shanxi Coal is truly performing. Today the offer is “up to $12”. Tomorrow it could be nothing, or $5 or $10. Only Zhao knows. Only Zhao will win in this rigged game.
So what do I expect PUDA shares to do if they ever reopen for trading? The legal quagmire may never get sorted out. PUDA may never trade again. PUDA will clearly not be able to consolidate the earnings (most likely losses due to the tremendous cost of the debt in 2011) of its Shanxi Coal subsidiary.
I estimate book value of PUDA’s investment in Shanxi Coal is $3.41 per share. Zhao’s “up to $12” offer is purely political to temporarily appease purchasers of the most recent public offering. Perhaps, if all goes well for Zhao, he will decide to fund his offer 12-18 months from now. I wouldn't bet on it. I suspect most serious investors share my point of view. So if the shares ever re-open for trading and if Zhao’s offer is still on the table, I will make the wild guess that the shares will settle into the $8.4 to $9 range (reflecting the 25-30% discount other LBO plays are averaging).
But this price is a steep premium to the $1.91 valuation CITIC paid less than a year ago so I believe the shares would then likely drift lower as Zhao is obviously not going to be in any hurry to advance such a premium priced offer until serious uncertainty over Shanxi Coal’s financial solvency is resolved, for better or for worse.
Disclosure: I am short PUDA.