Tuesday, March 10, 2009

What is China Security & Surveillance Hiding from Stockholders?

China Security & Surveillance (CSR-$2.67) said it expects 2009 earnings of $2.16 to $2.26 per share on revenue of $600.0 million to $630.0 million. Why then, is the stock of one of the largest digital surveillance providers in China selling for less than two times earnings?

The share price of CSR has lost 80 percent in value this past year, some of which can be attibuted to the 84 percent decline in the Shanghai Composite Index. Some investors remain concerned, however, that accounts receivables due from customers rose $73.8 million year-on-year. As Days Sales Outstanding, or the average amount of time that elapses before payments are received from customers, climbed only seven days to 91 days, the increase in AR likely resulted more from rising sales than collection issues.

A bigger worry was that gross margin in the installation segment fell 160 basis points to 27.3% in 2008, as customers from larger projects demanded higher discounts. Most of CSR’s revenues derive from the installation of surveillance and safety systems [73 percent], which are generally non-recurring. Consequently, it is likely that margins will fall further in coming quarters as discounting is the cost of business necessary to ensure “Safe City” contract wins from renminbi-starved government customers looking to save monies on their surveillance and safety budgets and other commercial clients.

On the surface, the balance sheet looks clean: debt service coverage was 2.6 times annual interest payments; cash flow used in operations of $39.1 million resulted principally from increases in inventories and AR [to support sales growth]; and, working capital was a comfortable $231.9 million at December 31.

Sun Tzu wrote in The Art of War: “Even though you are competent, appear to be incompetent. Though effective, appear to be ineffective.” The reverse is also true—and that is my biggest problem with CSR—and most PRC-based companies: lack of transparency.

Chief Executive Guoshen Tu and his investment entity Whitehorse Technology Limited beneficially own 32.9% of the outstanding common stock of CSR. On January 11, 2008, Whitehorse sold $50 million in aggregate principal amount of Exchangeable Senior Notes due 2012 to “un-named” third party investors not affiliated with the company (when CSR stock traded at $20 a share). In connection with this transaction, Whitehorse and Mr. Tu pledged 14.7 million shares of their common stock in CSR. In my opinion, the precipitious decline in the value of CSR shares is directly related to a “blow-up” that occurred in this less-than transparent lending transaction:

  • If the market price of the shares pledged by Whitehorse and Mr. Tu fell below $150 million, Whitehorse and Mr. Tu were obligated to pledge the number of additional shares in order to increase the aggregate value of all of the pledged shares to $150 million. As, the value of CSR fell more than 80 percent in the last year, I question whether or not Whitehorse and Mr. Tu had—and have—enough equity to meet potential margin calls. Supposedly, Tu and Whitehorse are not in default on this note, according to the 2008 annual report.

In 2007, CSR received $120 million from Chicago-based hedge fund Citadel Equity Fund, which included common stock convertible provisions. The Notes were convertible, by the holders, at any time on or prior to maturity, into common shares of CSR initially at the conversion price of $23.60 per share (equal to 9.9% of the common stock outstanding). HOWEVER, the exchange was subject to semi-annual reset of the conversion price. It is not known what the new exercise price will be—although investors should expect an adjusted reset at a significantly lower price than $23 a share (which will be dilutive, too).

The share price may look like a bargain at under $3.00 a share—until one begins to consider the stories not being told….

Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

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