China Security and Surveillance Systems: Best Opportunity I've Seen In Years

I am taking China Security and Surveillance Systems (CSCT.OB) above my normal 10% target position because it is the single best opportunity that I have evaluated in the last several years. This takes it to 12% of the portfolio and if it falls further, I may buy more.

To recap the opportunity (see initial writeup), the company is a Chinese security company focused on the video surveillence industry. They are a leading player in China in an industry segment that the government is requiring capital spending of companies and local governments -- to add video surveillance to curb the threat of terrorism.

-- Growth Company - earnings will grow about 35% this year and are expected to grow 50% next year.

-- Discounted Price - at current levels the company trades for 17x 2007 likely EPS and 11x 2008 expected EPS. The company trades on the Nasdaq bulletin board and is thinly followed on Wall Street.

-- Catalyst to Erase Discount - the company has received approval to begin trading on the NYSE once it can appoint the requisite number of independent board members. Once they reach the NYSE, more institutional investors will be able to buy the stock and I expect in increase in valuation.

Disclosure: Author is long CSCT.OB

Comments

[Brennus]

My notes show CSCT did a financing with Citadel for a nominal amount of senior convertible notes. The notes are convertible at $23.60 per share & due 2012. If the notes are not converted before they come due the company (CSCT) must repurchase them at a price which provides 15% CAGR to the lender. There are mandatory conversion clauses if the stock price is $40 in february of 2010 or $45 in february 2011. Cash interest payment on the notes is 1% annually.

According to GAAP, CSCT have to record interest expense as if the make-good, repurchase bogey were an actual cash expense. Which is to say they are recording interest expense as if they were paying 15% on the note when in reality cash interest expense is only the 1%. That's a lot of dough...17MM annually & 4.25MM per quarter.

Per their most recent 10q, basic share count was 34.94MM. So we are talking about a 12 cent per share non-cash interest expense charge every quarter. You mention a 17x 2007 EPS multiple...does your 2007 EPS model contemplate this non-cash charge to earnings or do you back it out (since it's non-cash)? If you're rolling it in & still think the company will earn ~ a buck on 07, this stock really is a buy.