China Security & Surveillance Technology, Inc. Q3 2008 Earnings Call Transcript

China Security & Surveillance Technology, Inc. (CSR)

Q3 2008 Earnings Call

October 28, 2008 8:00 am ET

Executives

Bill Zima - SVP, Integrated Corporate Relations

Terence Yap - CFO

Analysts

Chenyi Lu - Brean Murray, Carret

Ian Zaffino - Oppenheimer & Company

Adele Mao - Susquehanna International

Jeffrey Kessler - Imperial Capital

Brian Gesuale - Raymond James

Kun Tao - Roth Capital

Michael Kim - Imperial Capital

Adele Mao - Susquehanna International

Presentation

Operator

Good day, everyone. Welcome to the China Security & Surveillance Technology Incorporated third quarter 2008 Earnings Call. Today's conference is being recorded.

At this time, I would like to turn the call over to Mr. Bill Zima of Integrated Corporate Relations for opening remarks and introductions. Please go ahead, sir.

Bill Zima

Thank you everyone for joining us for the China Security & Surveillance Technology's third quarter 2008 earnings call. With us today is Terence Yap, China Security's Vice Chairman and Chief Financial Officer.

Before we get started, I'm going to review the Safe Harbor statement regarding today's conference call.

This conference call may contain forward-looking statements concerning China Security's business, which are intended to be covered by the Safe Harbor forward-looking statements covered by the Private Securities Litigation Reform Act of 1995. The actual results may differ materially depending on the number of risk factors including, but not limited to, general economic and business conditions, new product developments, installations, market acceptance, additional competition from existing and new competitors, changes in technology and various other factors beyond the company's control. All forward-looking statements are expressly qualified in their entirety by the cautionary statement and risk factors detailed in the company's filings with the SEC. China Security undertakes no duty to revise or update any forward-looking statements through select events or circumstances after the date of this conference call.

At this point, I'd like to turn the call over to Terence Yap. Terence, please go ahead.

Terence Yap

Thank you very much, Bill. Good morning everyone to those in the US and a very good evening to those participants in Asia. Welcome to our third quarter 2008 conference call. Today, we will discuss our financial results, talk about recent developments and our strategic plans, and conclude with our outlook for the remainder of 2008, and guidance for 2009.

First of all financial results. Even in the context of a challenging global economic environment, we are satisfied with out third quarter results. We continued to strengthen our brand within China and further firmed our foothold as a leading integrated provider of security and surveillance services.

Revenues in the third quarter grew 82.3% to $119.3 million compared to $65.4 million in the third quarter of 2007. Our revenue mix has also changed since last year. Our installation revenue in the third quarter totaled $86.8 million or 72.8% of revenue, compared to $40.8 million or 62.4% of revenues in the third quarter of 2007.

Manufacturing revenues were $21.4 million or 18% of revenues versus $24.6 million or 37.6% in the same period last year. And during the third quarter, we continued to build lour distribution segment to capture demand for security and safety products, including intrusion security, access control and video management systems. Out distribution segment contributed a healthy $11 million or 9.2% of our overall revenues.

Organic revenue during the third quarter 2008 was approximately $106.21 million or 89% of revenues as a result organic revenues grew during the quarter by $56.75 million or 114.7% from $49.46 million in the third quarter of 2007.

Non-organic revenue or revenues of acquired companies was approximately $13.08 million or 11% of total revenues in the third quarter of 2008. We are pleased with both our organic growth and our growth from acquisitions during the year, as we continue to stimulate growth in those businesses by applying the strong marketing and branding China Security.

Despite the global economic crisis, we continue to see demand for our products and services in China both from the government sector and private sector. The Chinese government continues to execute on a Safe City programs, which requires the development of IT security programs and installation of electronic security surveillance systems. The government sector as a percentage of our total revenues was approximately 50%.

Our corporate sector has also been a strong performer. Our projects in the third quarter included, transportation management systems, gasoline stations, community centers, shopping malls, business centers and entertainment venues, such as bars, cafes and nightclubs. Corporate revenues at a percentage of our total revenues totaled roughly 49% for the quarter.

Third quarter gross profit increased $12.27 million or 62.2% to $32.01 million from $19.74 million for the same period last year. Gross margins for the third quarter were 26.8% as compared to 30.2% for the same period of 2007. Gross margins of installation segments and manufacturing segment were approximately 25.7% and 32.2% respectively, compared to 31.8% and 27.3% for the same period last year. Gross margin of our newly established distribution segment was 25.1% in the third quarter, up sequentially from 21.6% in the second quarter of 2008.

Our overall gross margin was impacted by a need for accelerated installations for security projects during and before the Olympics, which required us to pay overtime and premium for outsourced labor. We believe the demands for accelerated installation were driven by the timing of the Beijing Olympic Games and we do not foresee this type of spending continuing in to the future quarters. We continue to expect full year margins of at least 30%.

Selling and marketing expenses increased 131.5% to $3.38 million in the third quarter from $1.46 million in the prior year, primarily due to the integration of our acquisitions, as well as increased promotions of our brand and products.

General and administrative expenses increased 161.3% to $7.42 million in the third quarter from $2.84 million in the prior year, primarily due to the integration of acquisitions and additional staff, the increased cost associated with improving our internal controls, and professional expenses related to costs of being a publicly traded company.

Also included in general and administrative expenses, in the third quarter, was a $3.6 million non-cash employee stock compensation expense, which was lower than expected, as we continue a thorough review of executive compensation packages.

Income from operation increased 17.8% to $15.33 million from $13.01 million in the prior year's third quarter. Operating margin decreased to 12.8% from 19.9% in the third quarter last year, which was mainly due to lower gross margin, increasing non-cash expenses as well as higher selling general and administrative expense. The net income in the third quarter of 2008 decreased 21.8% to $9.15 million from $11.7 million in the same quarter last year.

It is important to note that the third quarter of 2007 also included a gain from the land disposal of $5.52 million or $0.14 per share, which was not noted in the third quarter of this year. Net income per diluted share was $0.20 versus $0.29 in the third quarter 2007.

During the third quarter, we recognized $5.36 million or $0.12 per diluted share as the redemption accretion on convertible notes. We also incurred $3.6 million on $0.08 per share in the second quarter for non-cash employee stock compensation. This was lower than our guidance. But our Board and our management team has continued a review of stock-based compensation packages.

Lastly, we incurred approximately $2.51 million or $0.05 per share in the quarter related to depreciation and amortization of long-lived assets. Adjusted for non-cash items as well as one-time gain associated with land use rights and property disposed in last year's third quarter, diluted earnings per share increased 40.6% to $0.45 in the third quarter compared to $0.32 per diluted share in the third quarter of 2007.

We are very satisfied with this year-over-year performance, especially given that our diluted share count increased 13.9% in the third quarter of 2008 to 46.15 million shares from 40.51 million in the third quarter of 2007.

Our effective tax rate for the third quarter was 7.9% compared to 18.1% in the same period last year. We're able to improve in our tax planning of various subsidiaries which resulted in certain subsidiaries and joint one-off tax exemptions. However, due to the non-tax deductible expenses, we expect to see fluctuations in the effective tax rates over the next few quarters.

In the third quarter, our backlog was $65.2 million, up sequentially from $42.2 million in the second quarter. Once again, in the third quarter, we have not included the letter of intent, framework agreements and various other agreements as subject to final individual agreements, which will be entered into later date.

The total backlog value of all LOIs and framework agreements that we have signed since the beginning of 2008 is approximately $300 million. We expect the majority of this total backlog to be realized in 2009. And these LOIs and framework agreements provide us with a confidence in our 2009 guidance, because the balance sheet is a snapshot at the moment in time.

There are a few things I'd like to address specifically. As of September 30th, 2008, our cash balance was $65.93 million, down from $88.6 million at the end of the second quarter. The main reason for the declining cash is due to buildup of inventory that was necessary in order to meet above mentioned LOIs and framework agreements that are in place, but still subject to final binding agreements. Still, we must be prepared to fulfill these agreements and of purchase inventory that we are confident we will be using to generate revenue in next several quarters.

Our inventory increased in the quarter to $85.7 million, up from $40.62 million at the end of second quarter in anticipation of filling these agreements. In addition, (inaudible) due to contracts that are currently in progress.

Net cash of use for the operating activities was approximately $30.5 million in the third quarter compared to net cash provided from operating activities $11.3 during the same period last year.

Our accounts receivables also increased in the quarter to $131.93 million, up $95.95 million at the end of the second quarter. This is primarily due to the timing of the completion of several projects which were completed and built at the end of the third quarter. Because of the Georgia revenue base comes from government contracts, we believe these accounts receivables are collectable and that the credit of local and national government are reliable.

As a results, while we would prefer to have some other accounts receivable balance in our books, we do not see this as a credit concern or as residue affects of the current credit problems globally, but rather the traditional timing of payment for receivables from the government entities in China.

As a result of higher accounts receivables, our days of sales outstanding increased in the quarter to 99 from 94 days in the second quarter. As we stated in our last quarter's conference call that the government sector continues to grow, we expect DSOs to increase accordingly as our fulfillment of Safe City contracts commissioned by the government entities entered longer payment cycle. Nevertheless, with the China Construction Bank and IBM leasing facilities, we believe we're well capitalized to sustain these collection cycles.

Prepayment and deposits increased to $7.18 million, up from $4.98 million in the second quarter as a result of robust business activities. Total debt at the end of the third quarter was $157.61 million up from $137.81 million at the end of the second quarter. Our working capital at the end of the third quarter was $207.09 million versus $188.3 million at the end of the second quarter.

Let me touch upon our recent developments and strategic plans. First, we continue to build CSST as a preferred solution provider over the corporate and government sectors of China, as well as internationally. We continue to see strong demand for our production services from various business customers, government organizations. Our Safe City assets continue to provide us with confidence in our projections and we have not seen any slowdown of this business even after Olympics.

Our corporate sector business also remains healthy, and we continue to add contract wins to our backlog. As we continue to strengthen our position as a leading security and surveillance company in China, we have been focusing on increasing our Safe City revenues. During the quarter, we announced several Framework Agreements. In August, we announced Safe City Framework Agreement with Shouguang City valued at approximately $44 million or RMB300 million. And in September, we announced a Safe City project Framework Agreement with Nanjing's value at $29 million, approximately RMB200 million.

During the quarter, we also announced that we acquired 100% of beneficiary interest of Wandaiheng Industrial Park for total consideration of approximately $1.27 million or RMB146 million. This deal is expected to be close by the end of 2009. Finally during the quarter, we announced the following LOI. Number one, Coson is a leading company primarily involved in intelligent access control solution.

Secondly, DIT Digital is a Zhuhai-based well-known security company specializing in household consumption monitoring. Thirdly, Shenzhen Skyrise Technology, which is the leading a high tech and software enterprise specializing in developing, designing, manufacturing and selling digital video composition system.

We are excited about all of these partnerships and we believe that the products offered by each acquisition will add to a broad range of security solutions. As we seek additional Phase 3 project to expand our business into the residential and commercial market, these acquisitions will further position our company as a one-stop shop solution provider for security and surveillance needs.

Importantly, we remain comfortable with our cash position and secured sufficient financing to help us capture as much Safe City business as possible and meet our ongoing working capital and acquisition, integration need.

We will use our facility from a China Construction Bank to fund our working capital needs associated with the various Safe City projects, and we obtain the lease financing facility for Phase 3 projects within China from IBM Global Financing. These agreements provide us with a day-to-day operating capital needed to refuel the demand for Phase 3 contracts without compromising our balance sheet.

As a result, we believe we are well-funded to meet all our working capital needs under our current strategic plan. We are also exploring ways to increase our visibility and our participation in international markets and have taken steps to begin that process.

During the third quarter, we entered in two non-exclusive MoUs, with US technology companies to help us strengthen our security offerings. First, the FalconStor Software, we are exploring technologies in the areas of data storage and protection solutions. Second, with FLIR Systems, we will not only use FLIR thermal imaging core component in our securities and services, we will also work with FLIR to explore other technologic applications in the security businesses.

Finally, we announced an MoU with a Japanese company called Sojitz Corp. one of Japan's leading trading corporation to explore opportunities to distribute our production services, as it of China. We believe that these partnerships will ensure that we consistently improve and expand our product offerings throughout the world. We also believe that partnerships are the best way to expand internationally.

The second step we have taken to increase our visibility as well as our understanding of the international markets was our announcements that we have received approval for the dual listing in Dubai on a Dubai International Financial Exchange or DIFX. The Dubai listings, the first of its kind for a Chinese company and the first for New York Stock Exchange company will provide us with the wider market access and higher profiles in the Middle East and the [adjoining] region and give us a foothold in the surrounding areas, such as Africa, India and Pakistan.

Clearly, this is an area, where our products and services could be in significant demand, further strengthening our position in the Middle East with our announcement that some very well known and influential investors in the UAE have chosen to participate in a private equity offering of $10 million.

We view this investment as a strategic equity partnership, which provides us with relationships that will allow us expand our business operations in Dubai and in the UAE overall. The UAE economy is growing and a infrastructure build out in a UAE is significant, resulting in what we believe to get an increasing demand for our security related products and services.

We are excited about the possibilities of these developments and continue to research cost effective opportunities that makes strategic sense worldwide, as we expand our reach beyond China.

Secondly, we also continue to focus on larger projects. Historically, our average contract size of the Safe City projects were around $1 million to $1.5 million. However, since the second half of last year we have been increasingly signing on Safe City projects that range from $5 million to $8 million and more. We are really encouraged that we are now winning projects very much higher than that.

As a competitive strategy, we now typically sign Letter of Intents and Framework Agreements first, followed by finalizing individual separate contracts with specific scope of works and payment terms. These Letter of Intents and Framework Agreements are firm offers that has the same binding effect as the actual contracts. We should point out that a time duration to fulfill some of these larger contracts have increased from six to 12 weeks historically to as many as 22 to 25 weeks or longer.

We anticipate that the majority revenue of the projects recently signed will be recognized next year, which also provides us with a increased visibility moving into 2009. It is also important to note that we are seeing few competitors when bidding for larger Safe City projects.

Third, we continue to focus on our main revenue streams for 2008 and also develop a foundation for sustainable future growth.

As we discussed in our last quarter conference call our segmentation strategy calls for our company to be organized into five different divisions. We will use our expertise, and our technology, and branding to consolidate our business, integrate common processes and manufacturing functions, and manage each division to optimize productivity and efficiency.

The five divisions are, firstly, manufacturing of security and product safety products, secondly, system installation and solutions and services, thirdly, product distribution, fourth software solutions, and fifth, educational division.

Manufacturing and system installations, we are excited about the opportunities we are seeing in the marketplace for our flagship divisions. Our core two operating divisions, the manufacturing of the safety and security products and systems installation solutions are both growing strong. We are pleased with the traction we have established in the manufacturing of systems solutions business and the momentum we continue to generate. We still expect the two segments will continue to be our main revenue contributors for the remainder of 2008 and into 2009. And we are now beginning to explore opportunities on an international scale as well.

We continue to build the foundation for sustainable recurring services in the future. The establishment of a service division, the right to provide security related services for some of our Safe City projects and the continued expansion of our corporate systems and solutions project are all geared towards building of a sustainable customer base for our future security service business. Once again, we expect to see meaningful income revenues from services division sometime during the second half of 2009.

Product distribution, we are progressing steadily with the roll out of our distribution division, which now generates a small percentage of our overall revenue. We will continue to facilitate international security product vendors to enter the Chinese market by leveraging on our wide distribution network and sales network. We will explore distribution opportunities internationally as well. This will also allow us the opportunity to introduce a wider range of products and solutions into our systems installation business.

Software solutions, this division will specifically look into the development and deployment of software solution for security related applications over the existing infrastructure of our current and future clients. This division will not only employ the technological resources within the Group, it will also explore possible partnerships and collaborations with international software security solution providers. We do not expect to see meaningful revenues from this division in 2008.

Education division, we are currently working with the Chinese government to improve the standards of 7 million security personnel in China. We plan to offer courses and professional training programs that would be endorsed by the government.

Lastly, we continue to align our goals of our Management team with the goals of our stakeholders. We spoke about this on our last conference call but it bears repeating, our Management team made a decision earlier this year to extend the lockup on our shares until 2011.

Shares issued under the employee incentive plan will be subject for the vesting period. Management team will only be permitted to sell one one-third of the unrestricted shares annually starting on the 1, January 2009. We chose to extend the lockup, because we continue to believe in the long-term growth and health of our business. And we believe it is important for all our stakeholders to know that now, as much as ever, we have ongoing vested interest in making this business successful.

For the outlook of remaining 2008 and full year 2009, obviously, the current global operating environment is different one to our predictions. Still we will continue to see strong organic growth coming from primarily from manufacturing and system installation associated with Safe City programs and from the corporate sector.

We also expect to see continuous strong growth from our acquired companies. We believe that through our organic growth as well as our acquisition strategy, we have integrated a business that allow us to continue to strengthen our brand, increase our market share, offer the broadest possible line of products and services, and help us to continue to expand geographically.

With more than $65 million in cash on our balance sheet as well as the short-term working capital financing, we believe we are well-capitalized to meet our current strategic goals. We will continue to be opportunistic about our growth and acquisition strategy in 2009. And we should find compelling opportunities to increase shareholder value. We will explore all possible methods of executing on these opportunities. The shareholders are almost [technical difficulty].

Our strategy has always been to be the market leader in security and surveillance products and services within China. We have executed on our strategy successfully, and that begun to realize the benefit of it, as we begin to see high revenues and greater number of large safety contracts. We continued to capitalize on all security opportunities with solid infrastructure we have built.

Additionally, we believe that even taking into account of the current global economic situation, this is a great time to begin leveraging on our expertise and increase our brand awareness on a global scale. We remain confident about our business and about our growth of the security industry.

For the full year of 2008, we continue to expect to achieve revenues between $410 million to $420 million. We are also looking for full year gross margins in the range of 30%. We estimate that a non-cash interest expense associated with the redemption accretion on the convertible notes, the employee stock compensation and the deprecation and amortization for the full year of 2008 will be approximately $19.7 million, $13.4 million and $9.55 million respectively.

Excluding these non-cash charges, we expect to achieve an adjusted net income of $74 million to $82 million and adjusted diluted earnings per share of $1.63 to $1.79 in the full year of 2008.

This is based upon our current and fully diluted outstanding shares. For the full year of 2009, we are projecting revenues between $600 million to $630 million. Excluding non-cash charges, we expect net income to be between $108 million to $113.4 million. We expect adjusted EPS, excluding non-cash charges, to be in the range of $2.16 to $2.26. This forecast only includes contributions from all completed and pending acquisitions year-to-date.

In closing, we are working diligently to optimize shareholder value by focusing on growing our business strategically, by capitalizing on great opportunities, by committing resources to profitable Safe City projects, by executing our strategy carefully and successfully. We continue to be very pleased with our growth and we plan to continue to generate strong growth in our business across all operating segments.

This concludes my prepared remarks for the third quarter 2008. Operator, I am now ready to take some questions, please.

Question-and-Answer Session

Operator

(Operator Instruction). Our first question today will come from Chenyi Lu with Brean Murray, Carret.

Chenyi Lu - Brean Murray, Carret

Hi, good morning. A very good guidance, especially in 2009. So, my question to you is, we know the 2009 the financial market is going to reduce the GDP growth. So can you discuss your business as to both on the government side and corporate side? Do you expect any slowdown or you do you see your business that won't be impacted by the global market weakening? Thank you.

Terence Yap

Thank you, Chenyi. Well, as I mentioned before, fortunate or unfortunate, whenever something bad happens, our business tends to be highlighted. The security industry, not only in China, but globally, I believe is more of a countercyclical business.

In China especially, as the government continues to increase its social harmony, it tries to bring together the social equality within the country. We also continue to see that the government will continue to spend in ensuring that safety standards within China will continue to improve.

The incidence in China, of accidents, et cetera, all highlight the fact that the government needs to improve on the civilians' and also on security standards. But during 2008, we also saw the snowstorm, the earthquake, et cetera. This also highlights the fact that the government needs to improve in terms of its disaster recovery and emergency response.

Therefore moving in 2009, we strongly believe that the government will continue to spend, will continue to improve the social harmony within China. So, we are still optimistic and confident about our growth of the security market in China.

Chenyi Lu - Brean Murray, Carret

And one more question regarding your gross margin. I know this that quarter; gross margin is weak because of the one-time event. I also note that you reiterate your guidance of 30%. So, what do you see in 2009? Do you think you're going to still maintain about 30% going forward?

Terence Yap

Yes. From our perspective, we are still on track with the full year of 2008 in terms of 30%. The first nine months of this year where we have average gross margin of 29.9%, so we are tracking well on our gross margins.

As I mentioned before, we have now put in place the foundation, we are building the foundation for a long-term sustainable and statistically a higher revenue, higher margin business. So, as we integrate all the manufacturing facilities into the industrial park, as we bid for higher margin business, we are still keeping on track in maintaining 30% gross margins for 2009.

Chenyi Lu - Brean Murray, Carret

Great. Thank you. Those are all my questions. Very good quarter and also a very good guidance.

Terence Yap

Thank you, Chenyi.

Operator

Next we'll hear from Ian Zaffino with Oppenheimer & Company.

Ian Zaffino - Oppenheimer & Company

Great, and thank you very much. As you look into next year, you mentioned DSOs increasing. How much are they going to increase? Is there a way to quantify that?

Terence Yap

Once again, it depends on the government contracts. I've mentioned in past that we are trying to keep it below DSO of 100 days. Certainly this is one of our KPIs, or key performance indices, and this is something that my division, the finance division, is always looking at.

But as we move to 2009, as we have the China Construction Bank facilities and we also discussing with other financial institutions, other possibility of reducing the AR, especially with government contracts. We still try to aim towards keeping the DSO below 100 days hopefully or full year 2009.

Ian Zaffino - Oppenheimer & Company

Okay. Then, if you are looking to extend the DSOs as they are a way to make that up on the margin, or do you have that type of pressure, Terence?

Terence Yap

Certainly from our perspective, no. As we bid for larger contracts that are government, there are certain way of negotiating with them. Now even though we maybe put up a financing facilities and the cost of putting out a financing facility will also be borne by the government, so hopefully that will help us mitigating this with DSO factors as well.

Ian Zaffino - Oppenheimer & Company

Okay. A couple of other questions. As far as your cash balance, where is it held? Is that in renminbi or dollar revenues?

Terence Yap

Most of this is actually in renminbi, but we do have mostly in US dollars except in China.

Ian Zaffino - Oppenheimer & Company

Okay. But there are no cross-currency issues?

Terence Yap

No.

Ian Zaffino - Oppenheimer & Company

Okay. Assuming the payables are okay; then the other question would be what's the share count you are looking out for next year?

Terence Yap

Well, we base an assumption of about 50 million shares.

Ian Zaffino - Oppenheimer & Company

Okay. Alright. Thank you very much.

Terence Yap

Thank you, Ian.

Operator

(Operator Instructions). We'll now take a question from Adele Mao with Susquehanna International.

Adele Mao - Susquehanna International

Hello, Terrence, I have several questions. Number one, how much revenue did Olympics project contribute in the third quarter, and if we exclude those, what would you gross margin would be?

Terence Yap

Olympic project, well we've mentioned before that we don't have directly related Olympics projects for the Olympics itself. But, we have projects in the surrounding areas and also in other cities, so that's something that I hope you are asking about.

Adele Mao - Susquehanna International

Okay. The increased cost is because people are working extra time during the Olympics and had to work with the logistical issues that Olympics…?

Terence Yap

Correct. Thus, due to the Olympics there were a lot of distractions, as you say, as people turned the eyes towards the main event for the year.

Adele Mao - Susquehanna International

I see. I understand that, okay. My other question is related to your guidance. I want to get some clarification in terms of what's included and what's not? In the past, I remember you have excluded the three pending acquisitions DIT, Coson, and Skyrise, but I thought you've mentioned that these are included in 2009 guidance correct?

Terence Yap

Yes, because we assume that we're still working on trying to close in by end of this year.

Adele Mao - Susquehanna International

Okay. Also did you include any potential international opportunities from the Middle East or any revenues from educational training business that you recently set up?

Terence Yap

This does not include any new business.

Adele Mao - Susquehanna International

I see. Okay. Another question related to that, your backlog versus guidance, you mentioned that in addition to the $65.2 million of signed backlog there is an additional 300 million worth of LOI and framework agreement exiting the third quarter; could you just give us more color as to how you go from $300 million to $600 plus million in 2009, and whether these new contracts or you know to be expected new contracts will come from new customers or repeating customers going through additional construction phases.

Terence Yap

Right. As I mentioned before, internally we tend to have a visibility of 12 to 18 months. That's why we were very controlled in the guidance that we provided in for 2008. Now as we go into 2009, we roughly know what's going to happen in 2009 already. But we only are comfortable in reporting what we've signed, but those we're not signed but we're not going to controlling. So, internally we have a pipeline that we are comfortable with.

In terms of how much is new and how much is referral, I don't have a percentage breakdown, but I can tell you that quite a number of them are actually new installations, especially for the Safe City projects. But on top of that, we're also seeing that some of the governments are now moving to Phase 2 as well. So I treat that as referral. Yeah, you can say it is treated as referral as well.

Adele Mao - Susquehanna International

Do you see in terms of a contract value, does Phase 2 is typically higher or lower or it's just generally in line with Phase 1?

Terence Yap

Varies, it varies. We've seen some of them are almost the same. We've seen some of that larger, a lot larger than the Phase 1.

Adele Mao - Susquehanna International

I see, okay that's all I have. Thank you.

Terence Yap

Thank you.

Operator

And next we will hear from Jeffrey Kessler with Imperial Capital.

Jeffrey Kessler - Imperial Capital

Thank you and hello Terence.

Terence Yap

Hi, Jeff.

Jeffrey Kessler - Imperial Capital

I have a question regarding the cash flow and gross margin there have been flow with regard to installation and then the derivation of revenues once you get the installation. Clearly in this past quarter, you had a lot of installation going on which hurt the gross margin and hurt your cash flow, can you give us some idea on the seasonality, if there is any? Or more importantly, how much you see on the timing of the installations going into next year as to when we are going to see the greatest amount of installation relative to the service side of the business, so that we might have some ideas if they are going to be one quarter during the year or two quarters during the year when we should expect to see the gross margin and the cash flow be weakened a little bit by higher installation relative to the rest of the revenue base?

Terence Yap

We typically have seasonality in the first half of the year, especially in Q1, due to the Chinese New Year, et cetera. That's for the sales or the business, but in terms of the installation and everything, Q3, Q4 are typically the strongest period in terms of sales, because a lot of the deals and all our contracts are signed and installed. They have to be finished before the end of the year. Moreover, the government have to spend their budgets before the end of the year. If not, then they have a lot of explaining to do in terms of raising the budget by next year. So we typically see a rush or an influx of installation and business coming in Q3, Q4. So, typically Q3, Q4 are our strongest period.

Now, for Q3, because of the one of the events was Olympics, we saw the increase in rush of installations, (inaudible) more for laborers, because typically we actually contract out the manual labor and third party contractors do a lot of work. So at this point in time, what you are seeing that from our perspective, the negative operating cash flow for this quarter is mainly due because of the business in Q3 impacted by the Olympics et cetera.

Jeffrey Kessler - Imperial Capital

Okay. And yet you are saying still that for 2008, the last quarter the gross margin is going to go back up, because the percentage of installation relative to rest of the revenue base is going to ebb a little bit?

Terence Yap

Correct, and we are still maintaining the guidance of 30%. First, for the nine months of this year we are at 29.9%, so we are still tracking well.

Jeffrey Kessler - Imperial Capital

Okay. And as far as what you've stated before on no slowdown on the corporate side, I just want to reiterate another question that was asked earlier and that was clearly from the articles that we've seen, there is a slowdown in corporate China and you are saying that you have not seen that yet in the types of orders that you receive.

Terence Yap

Right. You got to remember that most of our business is not really related to the new property developments et cetera, we are still seeing our business in a gasoline stations, we are still seeing our business in the shopping malls while not new built but existing built, we are still seeing our business in karaoke's, pubs, discos that are clean place for installation systems, for a security business. So from our perspective we are still seeing a demand there. By usage, sort of revenue breakdown, the government sector is actually now representing a higher percentage about 50% of our revenues, it is mainly because a lot of the contracts that we are receiving are larger contracts from the government, but it doesn't' really mean that the corporate sector is slowing down, we are still seeing a growth in a corporate sector.

Jeffrey Kessler - Imperial Capital

Okay. One final question, clearly you are talking about larger and more sophisticated, and hopefully in some cases, higher margin contracts with the government, with regard to the Safe City's project. Do these projects involve night vision and the like and maybe higher, let's just say higher value-added services, and is that one of the reasons why you got involved with FLIR?

Terence Yap

Yes absolutely. Jeff, as I mentioned before, let me first start with the Safe City projects, a lot of it was really that was very rudimentary basic, but now we are seeing increasingly that government is now including a lot more or wishing to have a lot more high-tech installations. Our collaboration with FLIR is way to improve our product offering that we can offer to our clients, which includes thermal imaging capabilities within China. So, we are seeing that the government is now trying to get a little bit more sophisticated, but we believe that still a long way ahead and there are lot opportunities for technological partnerships.

Jeffrey Kessler - Imperial Capital

Is this something that the government is asking for or is this something that you are having to market and convince them that they need thermal imaging?

Terence Yap

Well, it's both. It depends on the application as well. So it's a matter of teaching, because don't forget we have been conducting seminars with the government. We constantly talk to the provincial, the city and to district police stations to demonstrate the various applications and technologies that we can showcase.

Jeffrey Kessler - Imperial Capital

Okay. Very good. Thank you very much.

Terence Yap

Thank you, Jeff.

Operator

Brian Gesuale with Raymond James has our next question.

Brian Gesuale - Raymond James

Hi, Terrence. Nice job on the quarter. I wanted to talk about the 2009 numbers a bit more. One, can you maybe give us an estimation, it sounds like the government business has actually accelerated, so as a part of the mix are we going to see that approach 55% to 60% of sales next year. Maybe talk about you overall level of visibility from the base business. It sounds like you have three quarter of 80% of the revenue kind of already tallied for and then maybe give us one or two things that could provide some upside and one or two things that could impact results a little bit next year?

Terence Yap

Right, I have to be careful here as well. I don't think that we'd be going to be a $1 billion company next year. This is something that needs to match everyone's expectations.

For 2009 numbers, we're certainly seeing a change in mix. I mean we started seeing government contracts were representing about 30% and 40%, and now it's 50%. So moving forward into 2009, we may continue to see a stronger percentage or greater percentage of the government sector coming in.

In terms of the possible upside, I think one of the things that we have not included is actually the new business opportunities in terms of the international, et cetera. At this point in time, I do not want to quantify it, because we're still at early stages of the development.

And there is also the possibility of other value-added services that we can add to the government, because as I mentioned, the installations that we're doing right now are really basic surveillance recording. Once we have a contract, it actually opens up a tail-end opportunity for future revenue contributions, because we can then add on other value-added services like software solutions or even integrated barometric detectors, et cetera.

So, for every phase of the contract that we receive, that's always a tail-end opportunity for additional revenues. But at this point in time, I want to manage expectations. I don't want people to think that we'll be going through $800 million, $900 million, $1 billion revenue. That will be dangerous from my perspective.

Brian Gesuale - Raymond James

Fair enough. One more thing on the expense line. It sounds like for '09, we're looking at 100 day DSOs, looks like gross margin is around 30%. Can you talk a little bit about the operating expenses, may be when you see some benefits of scale and consolidation of the manufacturing facilities where we might see a little bit of leverage on the operating line?

Terence Yap

Well, we have recently controlled the cost. If you look at the sales and marketing and G&A, excluding the non-cash compensation we have been controlling, sequentially has gone down. So, we are putting in place such mechanisms that have started to show a little bit of results.

But I want to remain conservative here in the sense that I want to make sure that to be honest that we're still are going through integration as we acquire the companies and we are acquiring a companies to integrating them together.

So, at this point in time, I am only comfortable in providing the guidance for gross margins. Certainly, from our perspective, from my financial controlling division, we are always looking at ways and means to try to manage the growth of the SG&A moving forward.

Brian Gesuale - Raymond James

And my last question is you are obviously going through an extraordinary growth phase. Can you give us a little bit of insight into further investments in working capital and what type of cash flow numbers we might expect with that 2009 guidance?

Terence Yap

While we have a not provided any of these on our website, but as I mentioned before, at this point in time, we have $65 million of cash. If the company continues to grow beyond expectations or we see opportunities, then there may be a requirement in terms of the working capital. But at this point in time, we are comfortable.

Brian Gesuale - Raymond James

Okay, great. Thanks a lot. Great quarter.

Terence Yap

Thank you.

Operator

Kun Tao with Roth Capital has our next question.

Kun Tao - Roth Capital

Hi, congratulations. Can you provide updates on your Safe City projects like how many of them have been finished or percentage of them have been finished and percentage of revenue being recognized?

Terence Yap

For the $300 million, a majority of it has not been finished at all. As I mentioned before, most of them will be recognized in the year 2009. But we have signed up a lot of other Safe City contracts that we don't typically announce unless that's got a strategic value. So I can't give you a fixed percentage on that sense.

For the quarter itself, we are slightly behind $100 million worth of contracts. And so, larger contracts are all Safe City projects. So I can't give you exactly out of $30 million how many have been completed. All I can say is that majority of it; the revenues will be recognized in 2009.

Kun Tao - Roth Capital

Okay. So typically, when you sign contracts, basically you start installation in three months. Is that right?

Terence Yap

Depending on the size of the contract, yes. On some of the smaller contracts, we take 6 to 12 weeks. But larger contracts may take about one to two quarters depending.

Kun Tao - Roth Capital

Okay. Also regarding last conversation with you, you have some issues in terms of the factoring agreement with China Construction Bank, but do you have any status on the recent finance agreement with China Construction Bank or any IBM financing for the Safe City projects?

Terence Yap

We have not seen any issues. Well, I'm not sure what do you mean by issues. But we are certainly seeing that the whole economic cycle in China impact a lot of the banks. But from our perspective, the banks are only willing to offer this line or this facility for government contracts.

And that's been very specific, maybe because the China Construction Bank or the National Bank in China know that the governments are credible. Therefore, we can only expand any facility or financially proceed with the government. That's all. We cannot try to corporate sector.

Kun Tao - Roth Capital

So the factoring agreement with China Construction Bank is still intact. Is that right?

Terence Yap

Yes, absolutely.

Kun Tao - Roth Capital

Okay. But you do have line of credit with China Construction Bank that is in addition to factoring agreement or not?

Terence Yap

Correct.

Kun Tao - Roth Capital

Okay. For the remaining acquisitions, you mentioned that you will finish all the six acquisitions you announced in 2008, is that right?

Terence Yap

For the three, yes the three acquisitions, yes.

Kun Tao - Roth Capital

Okay. What are your new acquisitions? What's your plan of acquisitions in 2009, and in which area, like in terms of products, productions line?

Terence Yap

We have not given any indication on that front yet, because we are still looking for opportunity. I mean, as you look at the market right now, I mean certainly comparing its valuations are very, very, very low. But, at this point in time, we've not announced anything at all. We are still opportunistic in making sure that whatever we buy will mix strategic value.

If you look at our historical view, we have been buying manufacturers who offer strategic product lines. There maybe opportunities for us to look at technology et cetera. But at this point in time, we have not provided any further details on this.

Kun Tao - Roth Capital

Okay. You did touch a little bit on the tax issue in the first and third quarter, what's your expectation for '08 and '09 on a tax rate?

Terence Yap

I am still maintaining effective tax rate about 25% to 30%

Kun Tao - Roth Capital

25% to 30%?

Terence Yap

Yes.

Kun Tao - Roth Capital

For the whole year?

Terence Yap

Yes.

Kun Tao - Roth Capital

Okay. Do you have any updates on your Citadel notes? Maybe talking to say that in terms of any payments or anything?

Terence Yap

Well from our perspectives, we're always talking to Citadel. We have a cordial relationship with them and if it does makes sense for us to move further then we will, but at this point in time I cannot comment too much on our discussions with Citadel.

Kun Tao - Roth Capital

All right. That's all for my questions. Thank you very much.

Terence Yap

Thank you.

Operator

We will now move on to Michael Kim with Imperial Capital.

Michael Kim - Imperial Capital

Hi, good morning, Terence.

Terence Yap

Hi, Michael.

Michael Kim - Imperial Capital

In the past you've talked about building your current base of revenues, and earlier in the call, you mentioned something along the lines of second half of next year. Are you looking to build that more out on the corporate side or is that something built into some of the government contracts that you are signing now or you actually also looking at residential?

Can you talk a little bit about were you're staying the marginal side of your business, and if you, from a rough standpoint is the significance, is that something around 5% to 10% exiting next year as a goal or would you consider that to be to aggressive at this point.

Terence Yap

Right. From the services division we are seeing that the breakdown of the residential would probably include monitoring, maintenance services and backhand data support. As we grow more on the government business, we are also seeing that we are able to bite on additional ongoing maintenance or ongoing data backup operating services for the government as well.

But, having said that, we are also seeing that there are opportunities for us looking to the residential areas. The gated communities, the condominiums in essence, so we are targeting both the corporate and the government. Corporate, I include the gated communities as the corporate sector because we do with the whole condominium rather than an individual homes.

Michael Kim - Imperial Capital

But, just from a rough standpoint what would you expect the monthly service revenue to look like on a per customer basis.

Terence Yap

Right, but please allow me to refrain from giving guidance at this point in time because we're still looking at the markets and I prefer to remain conservative at this point in time, to say that no we will probably see some revenues coming the second half of next year.

Michael Kim - Imperial Capital

Okay. In terms of your goal with that 5% to 10% of revenues exiting next year, would you consider that too aggressive at this point?

Terence Yap

Well, we hope so. Well, we hope to have those figures, but certainly, once again, because I want to withhold from having out any particular percentage as the majority of revenue contributions will still be coming from manufacturing and system installation of the business.

Michael Kim - Imperial Capital

Okay. And then, in the past you've also talked about taking a breather for the rest of the year on acquisitions through consolidation and focusing more on integration. Would you expect to see any change in that policy at this point?

Terence Yap

Well, we are still maintaining that. We are almost at the end of the year. We have started moving most of the guys into the industrial park. So we are certainly going to internal integration. So that's something that we're doing right now.

Michael Kim - Imperial Capital

Okay, great. Thank you very much Terence.

Terence Yap

Thank you, Michael.

Operator

And we have time for one final question. And we'll go back to Adele Mao from Susquehana International Group.

Adele Mao - Susquehanna International

Well, my follow up question was also related to maintenance, you just answered. Thank you.

Terence Yap

Well, okay. Thank you.

Operator

And that is all the time that we do have for questions. I will now turn the conference back over to our (presenters) for any additional or closing remarks.

Terence Yap

Well, ladies and gentlemen, thank you once again for attending this conference. From our perspective, in light of the current global economic situation, we still feel confident about our business growth within the security industry given that the need for security and surveillance and giving our clients a peace of mind has not slowed down, but has increased over the past month and hopefully within the next few years as well. As we continue to expand internationally, we hope to further grow the company to be one of the leading companies in security and surveillance business. Thank you once again.

Operator

And that does conclude today's teleconference. We would like to thank everyone for their participation and wish everyone a great day.

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