Petropavlovsk PLC: a textbook example of shareholders bailing out bondholders

Back in August, I published an article on the Motley Fool website entitled “3 Reasons Why Petropavlovsk PLC Shareholders May Be Left With Nothing“.

The point of the article was to highlight that all of the available cash flow from Petropavlovsk PLC (LON:POG) operations was being used to fund interest payments on its c.$1bn of debt — and that shareholders would eventually have to stump up cash or cede an equity share in order to fund a debt restructuring.

The end result, which we’ve now almost reached, is that the firm’s existing shares will become worthless. The whole situation is a textbook example of the risk that excessive debt levels poses to equity investors — and today’s refinancing news confirms I was right to view the stock this way.

At the time of my original article, Petropavlovsk’s share price was around 37p. Since then, it’s made steady progress downwards to its current level of 11.7p, which gives the firm a market cap of just £22m.

Refinancing deal

This morning’s c.30% plunge was triggered by news that the firm has agreed a refinancing deal for the $310.5m of bonds that are due to be repaid in February 2015. The firm cannot possibly repay these out of cash flow or existing resources, so shareholders will stump up $235m through a heavily discounted rights issue, at 5p per share. The remaining $100m will come from a new, five-year, convertible bond issue.

Here’s what this means for shareholders: most, if not all of that $235m will be used to repay debt, not to improve the business. Even after this has taken place, net debt will still be around $700m, so repayments will still be arduous and leave no room for a dividend, especially if the gold price fails to recover (or falls further still).

Selling the rights issue shares at 5p — a 66% discount to yesterday’s closing price — is a clear sign of distress.

Massive dilution

Note the difference between today’s market cap (c.$35m) and the rights issue ($235m): this difference, combined with the discounted price of the rights issue shares, means that Petropavlovsk’s share count will increase by 23 times following the rights issue.

Any shareholder not choosing to participate in the rights issue will be diluted out of existence: your share of the refinanced business will be 23 times smaller than it is at present.

The fact that the new $100m bond issue is convertible means that even more dilution is likely in the future, if the business recovers and the share price rises, some of these bonds will be converted to shares. On the other hand, if Petropavlovsk fails to recover, don’t rule out another refinancing. Either way, shareholders will be diluted.

Bondholders are not taking a loss

Shareholders should note that this is a textbook example of the superiority of debt funding.

The firm’s bondholders are not taking a loss: they will receive around 66% of their money on time, and the remaining third within five years.

This is all perfectly correct

In case you’re in any doubt, this is not a scandal — it’s perfectly correct!

When a company runs into trouble, debt holders rank above equity holders in terms of recovering their investment. It is perfectly normal for shareholders to be diluted or wiped out, in order to fund debt repayments and make bondholders whole.

That’s why investing in poorly-funded and heavily-indebted companies is a huge risk: because as a shareholder, you’re a sitting duck, waiting to be sacrificed to feed hungry debtholders.

Disclaimer: This article is provided for information only and is not intended as investment advice. The author has no financial interest in any company mentioned in the article. Do your own research or seek qualified professional advice before making any investment decisions.