Today we are adding China Security and Surveillance (CSR – 7.59) to our long term Buy and Hold list.

CSR is involved in the manufacture, distribution and installation of security and surveillance systems in the Peoples Republic of China (PRC). The PRC has designated 600 cities as “safe cities” and is committed to putting in comprehensive surveillance systems throughout all those cities over the next few years. So far the program is 28% complete, which suggests much more room for upside in the years ahead. CSR has grown sales from $107 mil in ’06 to an anticipated $600 mil this year. Moving down the road, the next area of growth will be in “E-Cities”, or digital cities. The PRC is committed to establishing integrated digital platforms and comprehensive information technology facilities throughout many larger cities. CSR just won two contracts for two “E-Cities” that totaled $284 million. CSR is a rapidly growing company, in an exciting growth area, that is expected to earn $2.34 in 2010. As such most investors would draw the conclusion that 15x earnings is reasonable and hence a $35 stock is warranted. Unfortunately the CSR story is not quite that simple. The first issue is the balance sheet, where the company entered into a loan agreement with Citadel for $110 mil in 2007, and which requires a $220 mil repayment in 2012. They are restructuring this loan. They both need one another and we are expecting some resolution very shortly as to how CSR can progress without the 2012 deadline looming over it. The problem is that this loan cannot be repaid from ongoing operations as cash flow from operations has not been sufficient. They did generate $17 mil in operating cash flow in the 1H, but as they grow so quickly they continue to service ever larger government contracts that take some considerable time to be repaid. This coupled with a much higher percentage of lower margin corporate contracts is wreaking havoc on the margins near term as well as hurting cash flow. CSR expects margins to bounce back with the realization of some larger government contracts in the 2H. The critics would call CSR a “value trap”, but we believe that the underlying strength of the business and forward opportunities are solid. If we fast forward over the next few months, we believe some clarity on the Citadel agreement, as well as much stronger 2H earnings, could well serve as a catalyst for sending CSR’s stock to a more reasonable multiple. The story is not without risk, but our confidence in the underlying fundamentals as well as the prospect for improved economies of scale suggest they can start to generate the cash flow necessary to turnover the cynics. The ’08 rebound high was $22, and we believe the stock can climb back to this level some time in 2010.