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China Fire & Security Group, Inc. (CFSG)

Q1 2007 Earnings Call

May 14, 2007 4:30 pm ET

Executives

Christopher Donnelly - Head of Corporate Communications

Brian Lin - CEO

Analysts

William Raleigh - Wainwright

Presentation

Operator

Good afternoon. My name is Henry, and I will be your conference operator today. At this time, I would like to welcome everyone to the China Fire & Security Group First Quarter 2007 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (Operator Instructions). Thank you.

It is now my pleasure to turn the floor over to your host, Christopher Donnelly, our Head of Communication. Sir, you may begin your conference.

Christopher Donnelly

Thank you, and welcome everyone to the China Fire & Security Group's 2007 first quarter conference call. The first quarter press release was released to the wire before the market this morning. On our call today is Mr. Brian Lin, Chief Executive Officer of China Fire & Security Group.

Before he gets started, I am going to read a disclaimer about forward-looking statements. This conference call may contain, in addition to historical information, forward-looking statements within the meaning of the Federal Securities Law regarding China Fire. Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events or performance, and underlying assumptions and other statements, other than statements that are historical in nature.

These forward-looking statements are based on the current management's expectations and are subject to risks and uncertainties that may result in expectations not being realized, and may cause actual outcomes to differ materially from expectations reflecting these forward-looking statements.

Potential risks and uncertainties include product and service demand acceptance, changes in technology or economic conditions, the impact of competition and pricing, the impact of government regulations, and other risks contained in the statements filed from time-to-time with the SEC.

All such forward-looking statements, whether written or oral, and whether made by or on behalf of the company, are exclusively qualified by the cautionary statements. Because forward-looking statements are subject to risks and uncertainties, we caution you not to place undue reliance on these statements.

Forward-looking statements made during this conference call speak only to the date, and are qualified by these cautionary statements.

With that out of the way, I would like to turn the call over to Mr. Brian Lin. Brian?

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China Direct (ticker: CHND.OB) is a diversified management and consulting company. Our mission is to create a platform to empower medium sized Chinese entities to effectively compete in the global economy. As your direct link to China, our organization serves as a vehicle to allow investors to participate directly in the rapid growth of the Chinese economy.

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Brian Lin

Thanks Chris and I would like to welcome our existing and new shareholders joining us today for our first quarter conference call. Before we get to the first quarter results, I would like to provide a brief overview of some of our recent initiatives and market opportunities.

As the leading fire protection company in China, we are in a unique position to work closely with not only the Chinese government, but other international agencies to establish new fire safety standards for both existing structures and new areas such as -- and not currently adequately protected. Therefore we announced that management participated in several industry conferences and discussions forums, where we showcased many of our proprietary technologies, most notably our patented linear heat detectors or LHDs.

For new investors, on the call LHDs are used for detecting temperature changes of the facilities that an LHD surrounds. For example, when a high voltage power cable is overloaded, the cable's surface temperature will rise, which can be detected by our LHD. This detection system will then alert the fire extinguishing system if necessary.

We are encouraged that our LHDs will be included in many field tests for new applications such as tunnel safety, and we believe by working closely with these international agencies we have the opportunity for our products to be [de facto] standard in the industry.

Tunnels are becoming increasingly scrutinized for their safety as they are a source of high warren traffic, which are susceptible to potential fire hazards. We expect these tests to be conducted over a one-year period, with the results helping to contribute in establishing fire standards for highway tunnels in China. We currently believe each could be a significant future opportunity for China Fire.

In addition to new applications such as tunnels, we will continue to target the Chinese industrial fire protection market. As we had stated in the past, industry research indicates that 80% of industrial manufacturers are not complying with current Chinese regulations dictated in the Fire Services Law enacted in 1998, and a Safety Protection Law enacted in 2002.

A goal the Chinese Government has made is to establish financial penalties for non-compliance. The owner of a building or press can be sued if the fire causes any significant damage. In the case of state-owned enterprises, the general manager will be removed immediately if there is an accident.

In addition to ramifications for prime operators, we believe that our system provides a high return on investments for our customers, as potential accidents could cause several-fold increases in damages compared to the cost of deployment of our system.

Industry experts feel that we have a main market, $900 million opportunity that is expected to grow in excess of 11% over the next five years.

With only a 3% market share, and as the largest domestic player, we have ample room for future growth.

Before we get to the financials for this quarter, let me provide some more color on the first quarter from the seasonal perspective, then add some commentary on new projects that we are working on.

Historically, the first quarter is seasonally intact as the result of Chinese New Year. We expect that our strong first quarter results this quarter was more different, since much of the margin was on holiday for a several week period. We do, however, expect the second quarter to be more active from a new contract on customer standpoint, as we had an extensive sales pipeline. I look forward to operating ventures with future wins.

Going forward, we are going to establish a policy that contracts in excess of $3 million. We will announce as we are awarded, as we better rely on our shareholders to track our progress. Also, we are going to provide our backlog on an annual basis rather than quarterly. The reason for this is that new contract wins vary quickly from quarter-to-quarter, and we believe that trying to analyze our backlog over such a short period could be misleading even these variations, and at the end of 2006, our backlog totaled 29 million. We feel that this has provided us with a good deal of visibility for 2007.

Historically, we have shown a high correlation between our reported backlog at the year-end and upcoming reported revenue for the year.

Finally, in addition to new contracts with domestic customers, we also pursue strategic OEM manufacturing partnerships with major international companies. This will allow us better leverage in our deployment and manufacturing expertise, domestic relationships, and the available capacity to not only gain a higher percentage of total solution sales, but also increase margins as we [replace] lower-margin product sales of other company products with newly manufactured products by Sureland. We hope to provide an update to investors on this initiative over the next several quarters.

Let me now briefly review first quarter 2007 results. For the first quarter, revenue increased 42.8% to $9.5 million compared to $6.7 million, as a result of improving sales execution, further penetration of the company's customer base in iron and steel industries, and continuing success in delivering more product and total solutions to industrial customers.

Our business benefited from a favorable trend across China--- for greater fire protection, and increased customer wins and penetration. Revenues during the first quarter also increased sequentially from the fourth quarter, despite the seasonal slowdown. Total solution accounted for 76.6% of the revenue, with product sales representing 22.1%, and the maintenance comprising the remaining revenue.

During the first quarter our three largest customers were Ma An Shan Iron and Steel, a power plant project in India, and Anshan Iron and Steel. Collectively, these three customers represented 50.9% of our total revenue.

Gross profit increased 42.7% to $5.0 million, as compared to $3.5 million in 2006, with gross margins unchanged at 52.8%. However, gross margins improved sequentially as a result of a high percentage of proprietary products sold.

Operating expenses increased by 24.5% to $1.7 million, compared to $1.4 million last year, with a primary year-over-year increase related to increased public company expenses. We did, however, based on concentrated efforts to control costs, reduce operating expenses as a percentage of revenue from 21% during the first quarter of last year, to 18% in the first quarter of this year.

Income from operations was $3.3 million in 2007, an increase of 54.7% compared to the $2.1 million in 2006, with operating margins of 34.5% and 31.8% respectively. Operating margins benefited from the formation focused on cost control.

During the first quarter we reported net income of $4.1 million and EPS of $0.15 as compared to $2.2 million or $0.09 last year. There was a non-cash benefit during the first quarter of this year resulting in a positive change in the fair value of derivates of $0.9 million. Excluding this non-cash benefit, pro forma net income was 3.3 million for the first quarter of 2007, or $0.12 per weighted average fully diluted shares, an increase of 33% compared to last year.

From the balance sheet perspective, we continue to remain in solid financial shape. Cash at the end of the quarter, including restricted cash, totaled $11 million. Accounts receivable totaled $14.7 million compared to $13.3 million at the end of last year, with DSOs increasing slightly versus the fourth quarter to 138 days.

Our receivables continue to be of high quality, with very little operation of accounts transitioning to bad debt expenses. Cash flow from operations was a negative $200,000, primarily relating to a modest increase in accounts receivables, and the timing of billings related to certain contracts. We expect to generate positive cash flow from operations in 2007.

Current assets increased 5.3% to $46 million versus the fourth quarter last year, with the company reporting working capital of $26.6 million on March 31, 2007. Total assets at the end of the quarter were $50.7 million, representing a 5.5% increase from the year-end. We have no long-term debt, and shareholder's equity is at $29.5 million.

Before we conclude the call, I would like to mention that in April we completed the formation of our independent board. We are happy to work with our four new members on the Board, and their experience in a variety of industry and accounting sectors will be a very valuable addition. With the completion of the Board, we have applied for a listing on the NASDAQ Capital Market. We will look forward to upcoming investors over the next several quarters.

Finally, as we mentioned in our press release in May, we have amended the original warrant agreement signed last October 27 and December 6 of 2006 between the company and the private placement investors. The effect of the amendment is that we will be removing the stipulations for us to treat these warrants as a derivative liability.

With this now removed beginning, in the third quarter we will not be subject to these non-cash charges, which have impacted our income statement over the last two quarters. We believe that this will make it much easier for our investors to gauge our financial progress.

In conclusion, we are pleased with our fourth quarter results, as they tract toward our internal expectation and the belief that we are well positioned to achieve our target of $13 million, and $0.46 for the fully diluted shares for 2007

With that, all of the way, I would like to open the floor for questions. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Your first question is coming from William Raleigh of Wainwright. Please go ahead.

William Raleigh - Wainwright

Good afternoon. Nice quarter. Could you tell us how soon the public transportation project, the tunnels, might come into actual revenues?

Brian Lin

Yeah, well, we actually had a project in 2006. We are well on the project, and some of the revenues are already recognized by the company in the first quarter of 2007. Looking forward, we are bidding quite a few projects right now as we speak, and we hope to announce some of the contract wins over these next several quarters. And I think the important significance of these highway tunnel opportunities, is that we are actively involved in setting up the fire standards and fire codes for this industry. So that would lay a good foundation for our revenue growth now going forward.

William Raleigh - Wainwright

Alright, and is there any price pressure on the linear heat detectors this year, or is that easing somewhat?

Brian Lin

No, we don't see pricing pressures for the linear heat detectors for 2007. Actually, we will see new standards, and actually at this moment, our product is the only product that is certified. We believe we have a very good chance of maintaining and getting better pricing for our linear heat detectors, because this is a much better product now compared to the products sold before.

William Raleigh - Wainwright

Okay. And just one last question about the R&D. The R&D number was substantially lower, does that mean you are actually committing last to that, or what is happening there?

Christopher Donnelly

What you said, one of the--

Brian Lin

Just for the first quarter, though Bill, I think the last year we have been focusing on a lot of R&D efforts for linear heat detectors, and that has been completed. So, that's why we have less R&D expenses this quarter. But we are spending and breaking up R&D efforts right now to extend into newer product lines, especially in the fire extinguishing system in the first quarter.

William Raleigh - Wainwright

So that we could expect an expansion in that in the latter quarter?

Brian Lin

Yes, it will be higher then. I think we will maintain the certain percentage of revenues in R&D.

William Raleigh - Wainwright

Okay, thank you very much.

Brian Lin

Sure, thank you, Bill.

Operator

Thank you.

Operator

Thank you. (Operator Instructions). Sir, there appears to be no further questions at this time.

Christopher Donnelly

Okay. Thanks everyone. We look forward to seeing you out at our upcoming conferences and road shows.

Operator

Thank you. This does conclude today's teleconference. You may now disconnect your lines at this time, and have a wonderful day.

TRANSCRIPT SPONSOR

China Direct Logo

China Direct (ticker: CHND.OB) is a diversified management and consulting company. Our mission is to create a platform to empower medium sized Chinese entities to effectively compete in the global economy. As your direct link to China, our organization serves as a vehicle to allow investors to participate directly in the rapid growth of the Chinese economy.

To sponsor a Seeking Alpha transcript click here.

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