rato_branco@yma...Simple Explanation of 10Q/A For Those Confused

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Minimum rating: 5 stars 4 stars 3 stars 2 stars + unrated 1 star + unrated What's this? Simple Explanation of 10Q/A For Those Confused 25-Dec-09 04:51 am I thought I'd give a clear explanation for those who are confused by all the shorts and bashers that want you to give them your shares on the cheap.

Ironically, the revised 10Q/A is GOOD news--it means that CKGT is about to uplist. Prior to meeting the requirements necessary to uplist to AMEX, small chinese companies often have to restate their earnings in accordance with GAAP rule EITF 07-05, which is the protocol for mark-to-market accounting of warrants and other financial instruments required by major exchanges. Unfortunately, this accounting rule tends to create a lot of unnecessary complication and confusion. That is why some small companies report non-GAAP earnings instead.

Let me explain further:

In 2008, when CKGT share price was much lower than it is today, the company raised cash through the sale of convertible preferred stock (CPS) and warrants to private investors.

The CPS is basically high-seniority stock that the owner can convert into common stock. At times, they stock has dividend guarantees.

The warrants are basically contracts that state that the owner can buy newly issued shares of stock from the company at a set price anytime between the issuance date and some expiration date.

As of 3Q 2009 the number of outstanding CPS shares and warrants was:

Shares of Series A CPS = 733,333

Warrants = 3,850,000

The various warrants that were issued were priced between $.60 and $1.25, and they expire in 2011. Remember that, at the time they were issued, CKGT stock price was much less than those values. The original investors still hold the warrants, and will eventually exercise them for a nice profit.

The significance of the CPS and the warrants is that they represent eventual dilution.

Per GAAP protocol EITF 07-05, rather than factor in those shares, and the dilution they will bring, when calculating the diluted EPS, the company is supposed to not count them, and then treat them as liabilities on the balance sheet that are then marked to market.

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Re: Simple Explanation of 10Q/A For Those Confused 25-Dec-09 04:51 am (cont.)

What does this mean?

Suppose that it is the 2Q 2009 and CKGT stock is at $.90. What is the mark-to-market value of a warrant to buy the stock for $.60? The answer--roughly $.30. So, per the rule, CKGT has to put $.30 * 3,850,000 of warrant liabilities on its balance sheet. That is the equivalent of what the company will have to give the investors if they eventually exercise the warrants. The company will have to give them 3,850,000 shares of stock each worth $.90, and will receive 3,850,000 * $.60 of cash payment in return, thus the company will be giving them the equivalent of 3,850,000 * $.30.

Now, for the quirk.

Suppose that it is now the 3Q, and the stock price is at $2.00. Now, the mark-to-market value of those same $.60 warrants is roughly $1.40. So, per the rule, the company now has to put $1.40 * 3,850,000 of liabilities on its balance sheet.

So, because the share price increased from the 2Q to 3Q, so too did the value of the liabilities on the balance sheet. That increase in liabilities offsets the company's actual earnings in the 3Q, making the earnings look smaller. Hence the downward revision.

But the loss that offsets the earnings is not a real loss. It is an illusion, a quirk of how the accounting is being done.

A more accurate--and also more conservative--way to evaluate the earnings of a company with oustanding CPS and warrants would be to add the them to the diluted shares (basically, assume that they have already been converted or exercised, because let's be honest, eventually they will be). You recalculate the diluted EPS using that number.

If you do that, you get about 24M outsanding shares. Obviously, we haven't accounted for the cash that CKGT will eventually get if the warrants are exercised (upwards of $2M), but we can be extra conservative and ignore that cash for now.

Here is their quarterly net income for the past two years:

4Q09 - TBD / 3Q09 - $3M / 2Q09 - $1.42M / 1Q09 - $0.69M

4Q08 - $2.3M / 3Q08 - $1.77M / 2Q08 - $1.04M / 1Q08 - $0.61M

The YOY growth rate has been increasing at a higher rate every quarter of this year. If you assume the same YOY growth rate for 4Q as for 3Q (69%), you get a 4Q net income of $3.89M, an annual net income of $9M, and an annual EPS (using 24M shares--the maximum shares assuming total conversion of everything into common stock) of .375. That's a P/E of 6.9 using today's closing price.

If you assume no growth from 3Q to 4Q, you get an annual net income of $8.11M and an annual EPS (using 24M shares) of .337. That's a P/E of 7.69.

Those are the EPS and P/E numbers that smart money will use to evaluate CKGT, not the numbers in the 10Q/A, which are deceptive and misleading because of the way the accounting is done.

Considering the rapid growth rate (in excess of 50%) and the low P/E, the stock is underpriced now matter how you choose to look at it. It is probably the fastest growing china small cap out there. It deserves a higher P/E than 7.

On a final note, all of the information about the CPS and warrants and their eventual effects has been readily available for more than a year. Smart money already knows about it--and has for a long time. Today's pullback was kneejerk, not well thought out, and that's why the stock rallied at the end of the day. I don't anticipate much weakness going forward, the market is quite used to this--it's applicable to CADC, CBPO, YONG, CAGC, and so on--but if there is weakness, you want to use it as an opportunity, particularly if you missed the train on the prior runup. This stock is a $6 stock, on the cusp of an uplisting. If you can get it on the cheap (you may not be able to), take it.

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Re: Simple Explanation of 10Q/A For Those Confused 25-Dec-09 11:25 am Superb response, Rato_branco

Big "Thank you" for taking the time to lay it all out with such clarity.

Question:
You say:
>"It is probably the fastest growing china small cap out there. It deserves a higher P/E than 7."


So-- what's a more "deserving" P/E... 8? 10-12? 15-20? Rating :
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Re: Simple Explanation of 10Q/A For Those Confused 25-Dec-09 03:37 pm I think a P/E of 25 would be quite fair for a company with a growth rate greater than 50%.

Of course, the market has to gradually evolve to a point where it is willing to give a company that kind of P/E. But in this case, it will. The first step in that evolution is an uplisting, which I think, from today's filing, is near.

If you add in the prospect that this company's "healthy cigarette" line could snag market share from a multi-billion dollar market, I could see this stock warrant a P/E of 60, in line with a hot company like Amazon.

Consider that if, over the next two years, this company expands to a P/E of 25, and doubles its earnings (as it is clearly on pace to do), you have a stock north of $18.

Sentiment : Strong Buy
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Re: Simple Explanation of 10Q/A For Those Confused 25-Dec-09 03:57 pm Again also here the PE7 is a backward PE so anyway everybody will focus on the forward PE from now on and that is around 4-5 for 2010 without any cig impact. If the cigs hit it big in 2010 we are talking about a monster here.

And the funny thing is that all the newbies who sell on monday based on fear created by some shorts will completely miss all of the fun in the next 18 months. LOL Rating :
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Re: Simple Explanation of 10Q/A For Those Confused 25-Dec-09 08:36 pm excellent description. monday may be the best last buying opportunity. Rating :
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RATO: Re: Simple Explanation of 10Q/A For Those Confused 26-Dec-09 10:48 am Thanks so much for your excellent summary. Can you tell me what other China micrcaps you like at this point for max appreciation over the next 12-24 months - thanks Rato!! Rating :
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