Really spectacular growth, cheap, there is a lot of value in many Chinese smallcaps. Is this a buy?

Wouldn’t you want to invest in a company that displayed the following revenue growth:

• 2004: $16.06M
• 2005: $32.69M
• 2006: $106.99M
• 2007: $240.19M
• 2008: $427.35M

The company is China Security & Surveillance Technology, Inc. (CSR), it is a Delaware holding company whose China-based operating subsidiaries are primarily engaged in manufacturing, distributing, installing and servicing security and surveillance products and systems and developing security and surveillance related software in China. (We’ll have a fuller description in a separate page shortly).

Whether you want to be an investor here depends, of course on profitability and share price. Let’s see profitability, the development already shows a few problems:

• 2004: $0.34 (per share, fully diluted)
• 2005: $0.39
• 2006: $0.85
• 2007: $0.91
• 2008: $0.72

Still pretty good, but not nearly as good as revenue growth. It’s makes this company quite Asian, expansion comes first, profitability second. In fact, these few simple figures already point to the main problems:

1. Customers are mostly non-recurrent
2. Hence the company, to a significant extent, ‘buys’ expansion
3. That expansion is financed by issuing new shares and debt and that (together with the integration efforts) is making net income growing much slower than revenues.

Actually, the profit figures are quite a bit better if one departs from GAAP accounting.

• Our net income was materially impacted by depreciation and amortization of long-lived assets in the subsidiaries we acquired, non-cash employee compensation recognized pursuant to revised Statement of Financial Accounting Standards (“SFAS”) No.123, Share-Based Payment (“SFAS 123(R)”) and redemption accretion on convertible notes we issued in February and April 2007. [Form 10-K,p29]

For instance, in 2008, that would more than double net income, adding $42.97M to get a net income of $75.57M, instead of $32.6M, or $1.67 per share, rather than the $0.72 per share according to GAAP.

Accounting that way would, according to analyst estimates, provide a consensus estimate of $2.12 per share for 2009, and $2.45 for 2010. [Yahoo] In that case, shares can be considered rather cheap (around $8), a p/e under four.

It also makes earnings growth over time more spectacular, as the difference between GAAP and non-GAAP accounting widens with time, it played much less of a role in the earlier years.

In the financial press, these non-GAAP figures are generally used, but is that justified? Well, here they are again:

1. Depreciation and amortization of long-lived assets in the subsidiaries we acquired
2. Non-cash employee compensation recognized pursuant to revised Statement of Financial Accounting Standards (“SFAS”) No.123
3. Share-Based Payment (“SFAS 123(R)”) and redemption accretion on convertible notes we issued in February and April 2007

The first two are debatable, although non-cash compensation is getting rather large for a Chinese company (we surmise that this is related to all these take-overs). The curious issue is no.3. What is “redemption accretion on convertible notes??”

Well, the company raised $110M by issuing two convertible notes with Citadel Equity Fund in February 2007, these notes are due in 2012. They bear only 1% interest, but, and there is the catch:

• if the notes are not converted before their respective maturities, the notes are to be redeemed by the Company on the maturity date at a redemption price equal to 100% of the principal amount of the notes then outstanding plus an additional amount of 15% per annum, calculated on a quarterly compounded basis, plus any accrued and unpaid interest. [Company PR]

So, they owe $110M, pay 1% interest, but make reservations for the possibility that these notes won’t be converted, which bares a rather steep penalty of 15% per annum. How are they doing?

• As of March 31, 2009, the Company accrued $38.72 million as a redemption amount payable under the notes, $5.38 million of which was included in interest expense in the first quarter of 2009. Unlike the annual interest rate of 1% that the Company is actually paying out to the note holders under the notes on a semi-annual basis, the Company would only pay the accrued redemption amount under the notes if the notes are not converted into the Company’s common stock before their respective maturity dates and are redeemed in accordance with their terms. Nevertheless, the Company believes that it must accrue the entire redemption amount under U.S. generally accepted accounting principles. [Company PR]

Is there any reason to expect there won’t be a conversion? Well, not that we can see. They have three years to go still and have already reserved a good deal of money in the case they won’t. However, conversion itself has other disadvantages.

At present share price ($8), the dilutive effect of conversion would be a rather large 13.75M shares, a significant percentage (30%) out of the 45M shares outstanding at present. However, like we said, there is three years to go until then, and a lot might happen to the share price until then.

However, we feel it would be one reason to take the GAAP net income, rather than the non-GAAP measures one finds in the headlines, as these convertible notes are going to have an effect on net income per share one way or another, unless the share price rises (which we think is actually likely) as to make the dilution much less substantial.

Speaking about the share price, let’s look at some charts. First, the 2 year chart.

You see that a much higher share price has reigned in the past (no surprise there), and with the continued growth it is not unreasonable to assume that before the notes are due, prices can move up substantially. How reasonable is it to assume that this is imminent? Let’s look at the last three months:

Well, you see that they had quite a rally of late, almost tripling in under two months, and they’re now bumping up the 200 day moving average, which is why we won’t advice an immediate buy. Just as eFuture (EFUT), this needs to consolidate and digest these large gains for some time, but it’s certainly an interesting play (although we have to say, if pressed, we rate eFuture higher still).