Thursday, 21 January 2016

The Math Behind Mr. Jiang Wang's Desire To List With Peak

A question that I got on more than one occasion from people is why would Mr. Jiang Wang be so willing to give up half of his business to list with Peak? Now there are a bunch of soft cushy answers I could give behind managing the stock symbol and getting listed on the NASDAQ, but I am going to focus purely on the math behind this deal so people can understand that this deal makes good sense from his perspective under most circumstances.

Recall that he gets 199 million shares at a price of 2 cents and 199 million warrants at a strike of 5 cents. Assuming the warrants get exercised, he will own 398 million shares at a total cost of $13.93 million. If the stock price was to hit $1, the total value of his holding would be $398 million and he would have made $384.07 million on this investment. With the stock price at 7 cents, he has made $10 million on paper just on the share component of the deal and he hasn't even transferred over anything yet, so early indications are very positive for him.

What does he have to give up to get a stock price of $1? Now let's ignore all growth initiatives that Peak is planning with the "Plastic Bank" (which we know will eventually be a platform for much more than just plastic) and any international expansion. Let's assume that the $1 stock price will only come through the transfer of existing business. Also for the sake of simplicity, let's ignore LongKey.

To justify a $1 stock price, and assuming a fully diluted share count of 700 million, a 10 Price-Earnings ratio and a 15% growth rate, Mr. Wang would have to give up business worth $70 million in net income. Keep in mind this is only a mathematical example being used to demonstrate his motivation. Recall that Peak has disclosed that it will receive business worth about $100 million in revenue during the year, with no disclosure on net profits as of yet.

If he were to give up a $70M net income business that grows at 15% per year, this would be the net income profile in the next 5 years:

           $70.00         $80.50            $92.58         $106.46         $122.43

Using a 10% discount rate, that would lead to an NPV of $348.45 million. Using the same 10% discount on the $384.07 million in investment gains to bring it forward one year (assuming PKK hits $1 in one year's time after the transfer in this example)  would lead to a marginally better NPV of $349.15 million. Capital gains are generally taxed at lower rates than personal net income, but I don't know enough about the existing corporate structure of his conglomerate nor about Chinese tax law to make a definitive statement that he will win on taxes. I also make the very simplistic assumption that he would be willing and able to sell his shares at any time (though this is dubious considering his long-term vision).

One could argue that I should be using a perpetual growth model instead of a 5-year NPV, but my response to that would be that this business can reasonably be expected to be worth well more than $1 per share beyond 2020 if its successfully executed and properly valued. So the two ever-growing impacts would offset each other as time went on. 

Now we know from my previous articles that Peak management and Mr. Wang are optimistic that PKK can reach $1, possibly within a year. And probably not with as much as $70 million in net income needing to be transferred over to the subsidiary considering that the current plan is for Peak to take over about $100 million in revenue which I'm sure is not at a 70% margin. So if Mr. Wang transfers considerably less than $70 million in net income and PKK can achieve $1, then he is a big winner. If on the other hand Mr. Wang transfers $70 million in net income and PKK fails to reach $1 within a year, then he ends up losing.

Much of this business plan is hinged upon Peak management getting the word out and ensuring a favourable valuation. If they do a really great job and the plastic bank idea is seen as a comparable to Alibaba and gets a 20 P/E or greater valuation attached to it, then everybody wins substantially - shareholders, Mr. Wang and PKK management. If PKK does just okay and achieves a 10 P/E valuation, Mr Wang is about breakeven and will very likely continue forward in hopes the business gets more respect as it develops. 

However, if the idea struggles to gain traction and stock is valued more like Chinese industrials at a 5 P/E or less, then even a 10 cent EPS will lead to only a 50 cent share price. Shareholders still win, at least the ones who are in at today's price but Mr. Wang does not. He may take this as a temporary headwind and push forward, or may give up on the idea. Only he knows how much his tolerance is for potential short term losses in order to see out his vision.

So the conclusion is that under normal circumstances and even fairly conservative circumstances, Mr. Wang can win on this deal. However, in very bad circumstances where the valuation is low, he can lose. That's why it is important for Peak to manage the investor relations side of the business carefully and why Mr. Wang has such an incentive to come to Canada to meet with investors and get them excited about his vision. He is taking a calculated risk that will very likely be profitable for him, but not 100% assured. In the worst case scenario the business he gives up will be worth more than the value of his Peak shares. I believe everyone will work hard to ensure that does not happen.


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