Monday, 21 January 2019

Peak Positioning Technologies Will Be Making 6% To 8% Loaning Up To A Billion Of OTHER People's Money

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Peak Positioning Technologies (PKKFF) (PKK.C) announced that it signed an agreement to service up to $1 billion in bank loans. Between that announcement and the follow up press release, we know the following:
  • PKK, through its ASCS subsidiary, will earn between 6% and 8% on up to a billion Canadian dollars equivalent worth loaned out to small businesses.
  • This is an annual rate payable monthly and the initial deal will be for a two year term. Meaning that PKK can earn up to $60 to $80 million in gross revenue per year, or $120 million to $160 million for the life of the agreement, with the expectation that the agreement will be renewed.
  • Through its partnership agreement with WU, loans serviced will initially be for Wuxi Rural Commercial Bank.
  • WU has a total of 19 partner banks, including the Agricultural Bank of China, Bank of China, China Construction Bank, HSBC and Industrial and Commercial Bank of China (ICBC). So there is ample opportunity to significantly increase this business relationship.
  • ASCS will provide WU with a security deposit representing 10% of the continuous aggregate value of the loans it services. Peak subsidiary Asia Synergy Financial Capital and former Wenyi now ASCS financial partner Qianzhou Small Loan Co. Ltd. will provide ASCS access to funding to meet its security deposit obligations to WU.
What is the security deposit and what are the risks involved?

This is obviously a very lucrative deal for PKK; the main caveat here is the security deposit. Up to $100 million will be required for this deposit, assuming the entire billion dollars is loaned out. That raises some questions:

How will the deposit be financed?
Who is the guarantor behind it? ASCS or Qianzhou?
Will this be equity dilutive to PKK in any way?
Will the deposit be a significant barrier for PKK being able to loan out hundreds of millions quickly? For instance, if $500 million in loans were ready to initiated immediately, would ASCS first have to raise the $50 million security deposit or is the expectation that this money can be raised quickly without an issue?
Is PKK responsible to pay any interest on the money used to finance the security deposit?

Finally - if ASCS is providing a security deposit, what exactly is the risk to the banks loaning the funds? The security deposit is 10% of the balance of outstanding loans, and it would be very unlikely that the default rate approaches anywhere near that level. As in other words, if ASCS is taking on all the risk of default, isn't this essentially a risk free loan? Of course the banks would love that. They would accept a 5-10% interest rate for virtually no risk of default. What a great deal! On PKK's side this would also make a lot of sense. This would function essentially as a loan to ASCS from the banks in order to re-loan that money to small businesses, something many shareholders have been clamoring for anyways. If future deals are structured like this and Peak proves to be profitable by keeping the default rate well below the agency fee, there is absolutely no reason for banks to not take the opportunity to lend out money that nets them 5-10% interest rate and is financially engineered to be "risk-less".

The obvious major risk factor here to this business model laid out in the agreement and to Peak is if the default rate spirals out of control. I have spoken with members of Peak management about this already and I believe a 2% default rate is a reasonable ceiling. Management thinks this default rate should be much lower, and they have identified two reasons for that opinion. First, the technology behind Cubeler and the ability to analyze reliable and timely financial data. Second, the culture for business in China is one that owners will do their absolute best to fulfill the financial obligations they have created. Still, desire to pay back your debts and the ability to pay back your debts are two different things. 

With that being said, I believe that Peak's business is starting at an ideal time. China is coming off of an economic boom where the economy is cooling off a bit and there are worries about a trade war with the United States as well as frosty relations with Canada. The irony of having had this business start earlier is that if Peak had loaned a lot of money out before Donald Trump became U.S. President, people would be worried if there were a lot of bad loans outstanding by now. Starting the loan business now means that a lot of the weaker small businesses out there would have been culled during this pullback. Plus the data collected by Cubeler is supposed to properly vet the likelihood of default. What better time to vet these companies than in a time of a slight slowdown and political turmoil? If they can survive this environment, they are more likely to survive any kind of business environment.

Estimating a cash flow model and valuation for this business

Until some of the questions I have laid out can be answered, I will have to make several assumptions based on reasonable and conservative scenarios for this business:
  • Peak can fully finance the security deposit at any given time at a 10% rate.
  • Default rate is 2%
  • Loan agency fee is 7%
  • ASFC and any other marginal ASDS business is cash flow/EBITDA breakeven
In Q3, PKK recorded $710K in revenue and -$236K in EBITDA in its first full quarter of operations for ASFC with very marginal revenues coming from the other subsidiaries. This is reasonably close to breakeven and the company has previously laid out projections that 2019 will be EBITDA breakeven. As a simplifying assumption, I will assume breakeven operations for 2019 outside of the deal announced today. So essentially I am valuing the company at today's deal only.

Assuming all billion dollars is loaned out:
  • Revenue over a 12 month period is $70 million.
  • Default rate of 2% leads to $20 million in bad debt written off.
  • Financing $100 million of a security deposit at 10% interest rate leads to $10 million in interest expense.
  • Cubeler makes 3-5% royalty on gross revenues. assuming a 4% rate on $70 million is $3 million.
The net effect of these four assumptions is $37 million. Employee and other like expenses should be covered off in the "EBITDA breakeven" scenario of 2019, but I will assume another $2 million for added growth and just to get to a nice even number - a 50% margin on the $70 million in revenue leads to $35 million in EBITDA.

Another way of looking at it is $3.5 million in EBITDA is generated for every $100 million loaned out. Again, if Peak management can answer some or all of the questions I have outstanding (either directly to me or in a future investor presentation), these numbers can be updated with greater precision.

Assuming Peak can loan out all billion dollars in a reasonable time frame, how much is $35 million in EBITDA worth? Without getting into specific price targets and using generic examples assuming 850 million fully diluted shares (I'm assuming enterprise value equals market cap which would value Peak's net cash position at zero, another conservative assumption):

$0.10 stock price = $85 million enterprise value and 2.4 EBITDA multiple
$0.20 stock price = $170 million enterprise value and 4.9 EBITDA multiple
$0.50 stock price = $425 million enterprise value and 12.1 EBITDA multiple
$1.00 stock price = $850 million enterprise value and 24.3 EBITDA multiple

I will let the investor decide what is a fair price for this one agreement. Let's see if there are more to come.

This was just quick, back of the envelop calculations provided to the reader for free. I don't get paid anything for this. As they say in life, you get what you pay for.

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