Wednesday 1 June 2022

PKK Margin And Guidance Analysis

I have been quiet on PKK recently, recognizing the sensitive spot I am in. As a long time shareholder, writer of numerous blogs about the company and creator of the Facebook investor's group, I know that my word holds a lot of influence. I touted a $0.20 to $0.50 price target on PKK for years, which after the two stock splits translated to a target in the $4.00 to $10.00 range. When it surpassed $10.00 I sold many of my shares and deployed that cash elsewhere. Because that's what you're supposed to do when a stock surpasses your price target. A 20-bagger is pretty good, no need to get greedy.

Now as I wait for my Petroteq tender money to come in, I have an opportunity to buy back every single share I ever sold on PKK as well as keep every position I purchased with PKK money other than PQE. Assuming the tender offer comes through without a hitch during the summer and PKK stays in this $2.00 range. So I have every incentive to see PKK's stock price as low as possible for the next couple of months. I am not the friend of any PKK longs right now, particularly not the "long and strong" types who obsess over and yap about the stock daily and are very obviously trying to flip for small gains or are looking for an opportunity to exit at a smaller loss. My remaining positon in PKK being in the dumps (shares acquired through the Cubeler deal valued at over $9.00) is well worth the buying opportunity once I have cash to deploy. That is, if I still feel there is a buying opportunity. 

I'm very proud to say that after over seven long years of holding, PKK has turned from a shell and a dream into a company able to achieve over $100 million in annual revenue. Management deserves full credit for this. I don't think it can be stated how difficult this is. I got off a call with Visionstate earlier today and the CEO is as bullish as ever. Yet VIS revenue came in last quarter at just $90,000. VIS has been around longer than PKK has.  FOBI was the hyped up back-to-normal COVID tracing story of the TSXV last year. And with its dozens of news releases and initiatives, could only pull in a pathetic $315,000 in revenue (and over $5 million net loss) last quarter. The vast, vast majority of companies on the CSE and TSXV will not come anywhere near the level of success that PKK has garnered so far. And keep in mind that PKK has done this focusing on a business plan in China, which usually has a negative sector bias to overcome. PKK hasn't been the beneficiary of crypto or cannabis or COVID sector hype, where money flows easily and capital raises at high prices can be had. It did benefit a bit from the general junior Canadian tech hype aided by Wall Street Reporter and the Discord promoters, but that wouldn't have worked without significant business developments and improving financials as a basis for the investment thesis. 

However, PKK now has a market cap over $200 million, about ten times what it was back in the 2019 doldrums. The stock has already been rewarded for its revenue growth. It has also come back down from over $1 billion in valuation at its peak. I would say that's punishment for lackluster bottom line numbers. My last post on PKK was ripping apart that ridiculous Grizzly Research report. I will always be here to defend the company from lies and made up issues. But I won't give the company a free pass when I find issues myself. The irony with the Grizzly Report is that it was so poorly done that it still looks like a laughingstock even though the stock price has declined around 80% since it was released. Had the "researcher" used actual financial analysis to come to a conclusion of something along the lines of "I don't think this valuation is sustainable because the company hasn't been pulling in strong margins" he would have looked smart. Instead of pretending to be Sherlock Holmes with his German-level understanding of written Chinese languages trying to find fraud where there is none, ending up looking like a clown.

This is where I get to my major issue. The revenue growth has been great. PKK more often than not has exceeded revenue guidance. The problem is there has been absolutely no traction on the margins, despite repeated promises from management that this is perpetually just around the corner. Here is a breakdown of segmented revenues by quarter going back to the start of 2020:

These numbers were grabbed from segmented reporting in PKK's financials and press releases for the adjusted EBITDA. Some calculations were required for Q4 as only annual results were posted. I double checked these numbers but I encourage others to do a check themselves for accuracy. Still, even if there is a mistake in there somewhere, I don't think it will change the story much. 

Some people will be familiar with this chart as I have shared it before. I also asked a couple of questions about the margins on the Q4 call but there was some miscommunication so they weren't answered very well. I wasn't on the Q1 call as it was close to 30 degrees and sunny over the past couple of days and I'm not anywhere near a computer under those conditions.

Revenues are up over 100% for all quarters. Great! The issue lies with the fact that nearly all of the growth is in the very low margin supply chain services. We see in 2020 that cost of sales ate up 98% of the margins in this revenue segment, leaving a gross margin of only 2%. When I and others had asked about this last year, management stated that once Gold River came online, some of the outsourced services would be brought in house and those margins would improve. We saw some minor improvement in Q3 2021 as COS % of Supply Chain Revenues dipped below 90%, but it was back up over this mark in Q4 and Q1 2022 again. 94% is better than 98% so there has been some movement in the right direction, but not enough to move the needle on overall company profitability.

The other half of this story is on the financial service and fees/sales from external revenues segments. This is the initial fintech business model of facilitating third party loans plus revenue from PKK's internal lending institution ASFC. These two segments have remained small with little traction on growth. ASFC was flat from 2020 to 2021, which is understandable given the impact of COVID on small business lending. However, the external fees segment was up 43% in 2021 and only 18% in Q1 2022. The lack of traction in these more high margin segments has resulted in overall gross margins (100%-COS % of Total Revenues in the chart above) declining year over year as the supply chain segment has grown to 95% of all revenues in Q1 2022 from 54% in Q1 2020. 

Given the mediocre and stagnant gross margins, it didn't surprise me when PKK released its latest forecast:


Revenues for 2022 are projected to be about $210 million, down from $345 million from October's guidance. EBITDA is projected to be $6.5 million, down from $82 million from October's guidance. The issues surrounding the lowered guidance are well understood. Last year the company expected to be listed on a senior exchange by now and able to raise more funds for growth and global expansion. That hasn't happened yet so it has had to pump the brakes a bit on its aggressive growth. Which is still projected to double in revenue year-over-year. 

The problematic pattern becomes more apparent when you look at July 2021 guidance, February 2020 guidance and October 2018 guidance. The guidance along with reported figures are summarized in the chart below:


PKK has a habit of forecasting large EBITDA numbers in outer years, then chopping those down once those outer years get close. Even if revenue is forecasted to increase. When PKK beat its guidance on both revenue and EBITDA figures in 2019, shareholders were understandably excited to see an updated forecast. So it came as a surprise that the guidance came in lower than 2018 projections. The February 2020 guidance was so poorly received by shareholders that the company released a letter later that day to explain it. The content of the letter can be summarized as follows:

  • Previous guidance assumed a need for capital investments. Company delayed that growth to avoid near term dilution.
  • The integration of Jinxiaoer and build out of the Cubeler network will lead to near term expenses that hurt profitability in the short run, but sets it up for stronger profits in the long run.

These are similar kinds of reasons being cited for the most recent decreases to guidance. This is not meant to be a slight on management. Trying to project a growing business accurately is very hard. Especially during this pandemic. But that's kind of the point of doing this analysis. Back in 2018 we were promised $56.6 million in EBITDA on 60% EBITDA margin in 2021. By February 2020 we were promised that figure on an improved EBITDA margin in 2022. That was increased to $82 million EBITDA - lower margin % number but much higher revenue - as recently as October 2021. And now once we are in 2022, that EBITDA number is slammed down to $7 million on $210 million in revenue, a mere 3% EBITDA margin. This ~$60 million in EBITDA that was promised to us by 2021 back in 2018 is now promised to us in 2023 on a revenue base of over $500 million. 

Doing a skim over reported numbers versus previous guidance, we see how revenue numbers from 2019-2021 are pretty much bang on to a slight beat. 2019 EBITDA beat guidance, but both 2020 and 2021 saw a consistent pattern. 2020 EBITDA went from a forecasted $20 million down to $4 million and came in $6 million below that at -$2 million. 2021 EBITDA went from a forecasted $56.6 million to $22 million to $12.5 million to $11.3 million and came in at $2.5 million.

I think that management is honest and trying its best to give us realistic numbers to work with. But by now I have seen enough of a pattern to know not to give any credence to outer year numbers, especially on EBITDA and net income. PKK is repeatedly encountering issues that affect its ability to meet its projections on profitability and has been recycling similar types of excuses for why it keeps happening. When the market cap is $20 million, I can overlook these issues because the stock is already cheap. When it's over a $200 million valuation, that's when I need to hold the company to a higher standard.

My outlook: Hold

I am putting a hold target on PKK at around $2. With such low margins, a 1x forward revenue multiple is fair. I'm not going to sell what I have left at these low prices, but I'm also not in a rush to buy either. I understand the potential market impact my words will create. Just to stomp on any fires right there - I have absolutely no intent to buy any PKK shares until I get my payout on PQE. That's at least two weeks away and I am fully prepared for another month's delay. I'm not trying to trash the stock to pick up cheap shares. If you look at some of my older blogs, my investment thesis that justified my $4 to $10 target prices remained consistent. For instance, this blog I wrote in January of 2019 focusing on the third party lending business. I came up with an estimate of $70 million in revenue and $35 million in EBITDA, numbers that were generally in alignment to both the 2018 and 2020 forecasts for 2021. I had a reasonable basis to justify my investment thesis. It's not me who has changed. It's the company that has failed to deliver on improved margins it has promised several times already.

What would get me to buy more of the stock again? Simple. First, demonstrated margin improvment. Not promises of Jinxiaoer or Cubeler or Heartbeat integration, not the onboarding of Gold River, not the promises of moving into higher margin sectors or expansion into Canada. Demonstrated numbers on a financial filing that show something better than 10% gross margins and 2% EBITDA margins. If that means paying $5.00 or more some time next year for shares, that's fine. That's still well below my average sell price and gives me plenty of time to deploy that cash on other opportunities over the next year. Second, if the stock price continues to drop. If I believe that $2.00 represents a fair value to hold shares, then logic would dictate that something below $2.00 represents a speculative buy before the company can demonstrate improved margins. What that price level is, I don't know yet. I'll figure that out after I get my Petroteq money, fingers crossed. 

*For those who are unfamiliar with the Petroteq offer, search for Viston $0.74 tender offer. Yes, it's trading at a 50% discount presumably a few weeks before the deal closes. No, I'm not going to explain why. Sick of talking about it. Just want my money. Do your own research. 


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