PKK doubled its revenue over the previous quarter and achieved positive EBITDA for the second quarter in a row in Q3 2019, just its sixth quarter of operations.
PKK also achieved positive cash flow from operations and positive operating profits for Q3.
PKK appears to be on track to achieve at least $6 million in revenue for Q4 with the potential to achieve positive net income.
Growth could be accelerated substantially upon the closure of an acquisition in Q4 that will enable PKK to roll out its services nationally across China.
I am maintaining a $0.50 target on PKK based on the expectation of $100 million in annual revenue and $45 million in EBITDA in the reasonably near future.
In September, I wrote an article on Peak Positioning Technologies Inc. (OTCPK:PKKFF) (PKK.C), called "Peak Positioning Technologies: A Chinese FinTech Play Quickly Heading Towards Profitability" that outlined in detail its FinTech business and various subsidiaries in China. Review that article for a refresher or introduction into Peak's business and the roller coaster history of ups and downs it took to get to where it is today. The purpose of this article will be to review the company's outstanding Q3 2019 financial performance and to analyze near-term growth prospects and issues potentially weighing down the stock. All figures are in Canadian Dollars.
In just its fifth quarter of operations, Peak demonstrated positive EBITDA for the first time in company history in Q2 2019 while doubling Q1's revenue. The company followed up its record Q2 performance by releasing even stronger Q3 2019 financial results last week. Revenue once again more than doubled over the previous quarter while adjusted EBITDA also more than doubled over Q2:
Source: Q3 2019 press release
- Total revenue for Q3 2019 was $4.5 million, a 137% increase over Q2 2019 and 535% increase over Q3 2018.
- Adjusted EBITDA was $719,000 for the quarter, a 118% increase over Q2.
- Peak recorded a net loss of $777,000, but that included a one-time write-off of $584,000. Excluding that amount, the net loss was only $193,000 so it is quickly closing in on becoming profitable on the very bottom line. Net loss excluding minority interest was $359,000. However, Peak already attained positive cash flow from operations of $1.5 million and operating profit of $323,000 for Q3.
These numbers track closely to my estimate of revenue in excess of $4 million and EBITDA in excess of $700,000 made in my previous article. The company fell just short of a small profit when excluding the write-off, but I believe there is a greater than 50% chance that net profits will be achieved for Q4. I am looking for at least $6 million in revenue and $1 million in EBITDA for the quarter as Peak will build on its growing loan book and base of FinTech services that saw it grow so strongly in Q3.
Even if Peak fails to achieve the numbers that I expect in Q4, it has already outperformed its own expectations prior to the start of the year. The company forecasted $9.3 million in revenue and $148,000 in EBITDA for 2019:
Year-to-date revenue is $7.3 million and EBITDA is over $1 million so chances are very strong that 2019 guidance will be substantially exceeded. Assuming revenue in excess of $10 million for the year, Peak's fully diluted market cap of $45 million leads to a revenue multiple of 4x and just over 1x of 2020 expected revenue. Even if Q4 revenue and EBITDA estimates were to miss my expectations and come in flat to Q3, I believe that there is minimal downside because Peak has not yet been valued as a growth stock despite showing exponential growth numbers. If Peak was to achieve no further growth compared to Q3, it would have $18 million in revenue next year. That would lead to a revenue multiple of 2.5x.
Risks going forward
Peak's Q3 result proved to the market that Q2 was not just a fluke and that its FinTech offerings in China are gaining traction. In my previous article I outlined four risks - management of the default rate on its loans, the technical performance of its platform, repatriating funds back to Canada and macro events such as the U.S.- China trade relations - to investing in Peak. There is another risk related to near-term dilution and/or refinancing from convertible debentures due in less than a month.
The ability to pay dividends is what investors ultimately look for when investing in companies on the stock market. A company that does business in China must structure itself in a way so that earnings made in China can be repatriated back to the country of origin. It's a complex process, but not impossible or else no one would ever invest in China. Peak management has stated that it will be able to pay dividends and the intent is to do so in the near future (my guess would be some time in 2020). However, until the money is in investors' accounts, it remains a potential risk. But not one that should be considered difficult to overcome.
Chinese trade and political relations between itself and the United States or Canada can change the market perception of investments in China, which can impact stock prices of companies that have business in the country. But I believe that the nature of Peak's business will not be impacted by either unless relations deteriorate beyond Cold War levels. The Chinese government, in an attempt to grow its economy through internal sources and no longer just relying on exports, has been pushing hard for banks to loan to small businesses. This could lead to an estimated amount of $418 billion U.S. worth of new loans to small businesses in China. My investment thesis states that Peak only needs around $100 million in annual revenue to be worth multiples more of its current stock price. Being just one small player in a lending sector with backing by the government should provide more than enough cushion for macroeconomic events. Small business loans in China are going to increase no matter happens between the country and its global partners or rivals.
The three more substantive risks going forward relate to Peak's ability to manage its default rate, provide the services it says it can provide and to handle the debentures coming due and future management of its balance sheet and cash flow.
The average interest rate on loans made by Peak's 51% owned lending subsidiary ASFC increased to 17.5% for Q3 2019. Loans at that type of interest rate obviously come with risk. Peak has continued to do a good job in managing these loans given the high interest rate attached to them. 92.1% of them are not overdue while 3.1% of the loans are considered problematic at over 90 days overdue. The allowance for credit loss is $345,000 or 1.7% of the total carrying value of the loans.
Source: Q3 2019 financial statements
This figure has increased since the end of 2018 but considering that ASFC only began lending in May 2018 this would make sense. The period of time that loans have been outstanding has increased from 8 to 17 months from December to September. The rate of default should continue to be closely monitored but if it can remain under 2%, Peak is doing extremely well given the interest rates on the loans.
In my previous article I identified the technical capabilities of Cubeler being one risk the company must overcome. While continued revenue growth is a sign that the platform's loan matching algorithms are performing as expected, Peak's aggressive growth in service offerings has created new challenges. A new line item that appeared in Q3 of outsourcing services totaled $2.6 million for the quarter:
Source: Q3 2019 financial statements
This one line item represented 58% of revenue for Q3, so it put a big dent into Q3's profitability even as the company set another record EBITDA figure. The line item was the result of the outsourcing of certain supply-chain related services such as warehousing and logistics that ASSC is not yet in a position to provide on its own. As a start-up with a small amount of registered capital, ASSC is restricted by the Chinese government from performing certain services. Management is currently working on a solution to this challenge, but there is no assurance of success nor the timing around it. If Peak finds a workaround to this issue, the announcement of success would be a near-term positive catalyst.
While it is a short-term roadblock to higher margins, it doesn't appear to be a short-term roadblock to profitability based on the trajectory of the company's financials. Since Peak is cash flow positive, there is an opportunity to increase ASSC's registered capital through internal sources of cash flow. However, this goal would be in direct conflict to the company's goal of paying dividends in the near future. Management will have a delicate balancing act between paying dividends, using free cash flow to reinvest into the business, or finding creative ways to finance ASSC and its other subsidiaries heading into 2020.
While the above headwinds will need to be managed in 2020, Peak has one final hurdle to overcome in 2019. The company has debentures convertible at $0.05 coming due on December 15. This was part of a $12 million raise to help create ASFC. 240 million warrants were issued (191 million of those warrants being previously existing and repurposed to minimize dilution) to essentially act as a conversion feature:
As of September 30, debentures worth a face value of $3.85 million leading to 77 million warrants upon conversion remain outstanding. These debentures must either be converted, refinanced or paid back within a month. While they are secured against company assets, as a debenture holder myself, I know that these debentures are in friendly hands and everyone holding them has an interest in seeing the company succeed. Based on the operating cash flow discussed above, Peak very likely has enough cash to pay back the minority of holders that insist to be paid back rather than to convert or to refinance. So this is not a matter of solvency.
The conversion or refinancing option each provide their own short-term headwind to the stock price. Anyone who converts adds free trading shares to the float. That could lead to selling pressure though $0.05 should be a hard floor. If people are willing to sell for $0.045 or less, they are better off asking for their money back or pursuing refinancing options rather than converting. However, should the stock spike to $0.10 in the near term, these converters would provide selling pressure.
Refinancing of the debentures would alleviate any short term selling pressure to the float as the expected wave of conversion in December would not happen. But as part of any refinancing negotiation, debenture holders could ask for a sweetener. This may result in additional dilution, such as the issue of more warrants at a higher strike price.
PKK's Q3 is one step closer to a $0.50 target as its exponential revenue growth shows no sign of slowing down
In my previous article I outlined a path to a $0.50 price target for PKK. A 45% margin on $100 million in revenue would lead to $45 million in EBITDA. A 10x EBITDA multiple would result in a $0.50 stock price based on a fully diluted total of 900 million shares outstanding. While considering the margin pressures and the potential increase to the float as outlined in the risk section above, the stock price has merely kept steady at around $0.05-$0.06 since the release of the Q3 results. However, the company itself certainly took a path towards these fundamental targets in Q3.
Peak's annualized revenue run-rate based on Q3's revenue of $4.5 million is $18 million. That would put it at just under one-fifth of the way through to $100 million in revenue. With the doubling of revenue over the last two quarters, Peak has shown that its revenue growth is exponential and consistent, not only quarter-to-quarter but month-to-month. The nature of Peak's business as a lender and provider of loan matching and other financial services to banks and small businesses in China means that its revenue increases steadily with time as its own loan book and those of its clients grows. To achieve the numbers it has done this year, the monthly results probably went something like this:
January, February and March: ~$315,000 per month
June: ~$950,000 (the introduction of its ASSC subsidiary contributed a significant amount to June's growth)
July: ~$1.2 million
August: ~$1.5 million
September: ~$1.8 million
If my monthly estimates are correct, that would mean October starts at a base of $1.8 million from September and builds on it. The three months of Q4 will likely exceed $2 million each in revenue and therefore the quarter will exceed $6 million in revenue. That would put Peak at 25% of the way towards achieving a $100 million revenue run-rate while there is no end in sight to its exponential growth. One cannot rule out the possibility that Q4 2020 could have revenue in excess of $25 million based on this trajectory.
This growth rate is predicated purely on existing operations. Those operations are centered in only three cities in China right now, Wuxi, Jiangyin and Xian. Peak disclosed in its Q3 2019 MD&A that it is close to completing another strategic acquisition that will allow it to rapidly expand its services all across China. The acquisition is expected to impact all of Peak's subsidiaries and will generate considerably more business for each one of them. It is yet to be seen how this acquisition will be structured, and it may involve share dilution. But if it is used as an accelerant for a national rollout of Peak's services across China, it will be well worth it. Investors interested in PKK should keep a close eye out for any press releases related to this potential acquisition or any other business developments being announced before the end of 2019.
Disclosure: I am/we are long PKKFF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.