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China Security & Surveillance a Tempting Buy, but Watch Gross Margins

China Security & Surveillance Technology (CSR) is down 27% over the past 12-months, but the price drop may offer an opportunity to buy a growing company in a growing sector at a compelling price.

China Security & Surveillance Technology, Inc. [[CSR]] is a manufacturer, distributer and servicer of surveillance and safety systems in China to both government and the private sector. The stock burst on to a lot of investors’ radar today with the company’s announcement of impressive results, but setting that aside for the moment, there is a lot to like about the company.

China Security & Surveillance By the Numbers

P/E: 15
Forward P/E (December 2010): 3.9
P/E-to-Growth Ratio (5-year): 0.14
Current Ratio: 2.6

Surveillance: A Growing Industry

It is probably not surprising that surveillance technology is a growth industry in China given its political regime.

China Security & Surveillance’s bread and butter is video surveillance, which is in high demand due to Chinese ordinances that require its installation in more than 650 Chinese cities. Also, the coming 2010 World’s Fair in Shanghai has China spending north of $6 billion on surveillance and safety equipment for the event.

The private sector in China also offers opportunities as video surveillance is becoming standard in places ranging from shopping centers to factories – and with unexpectedly high GDP growth in the most recent quarter, the global economic downturn is probably less relevant in China right now than any other country. On the earnings conference call today, the company noted:

“Our corporate sector has always been a strong performer. Our projects on the second quarter include banks, airports, gasoline stations, community centers, shopping malls, business centers and entertainment venues. Corporate revenues as a percentage of our total revenues totaled roughly 58% for the quarter.”

Impressive Second Quarter Results

Shares in the company jumped a giant 16.3% after China Security & Surveillance beats analysts’ EPS estimates by $0.01, as earnings came in at $0.39 per share, while revenues demolished expectations, rising 53% year-over-year to $141.9 million versus expectations of only $116 million. Even better, China Security and Surveillance also issued full-year guidance for EPS well above analysts’ expectations – $2.16 to $2.26.

A Stock Worth Watching with a Caveat

On the heels of a strong quarter and strong guidance, China Security & Surveillance is certainly worth watching. Its valuation relative to growth is fairly attractive right now – largely because the stock is down nearly 27%, even after today’s jump, over the past twelve months. Basically, the stock is still on sale right now.

A possible concern for the company’s future was mentioned in its conference call today:

“Gross margin for the second quarter was 21.9% as compared to 32.8% for the same period of 2008 due to a higher price competition in the corporate sector and lower margin from small scale projects. Gross margins for the installation segment, manufacturing segment, and distribution segment were approximately 21.5%, 27.8%, and 15.4% respectively compared to 34%, 35%, and 21.6% for the same period last year.”

Margins were maintained in the government sector, but with government contracts accounting for less than half of the company’s business, continued “price competition” could give future earnings’ estimates a real haircut. Hopefully, this is a temporary decline. On the conference call, the discussion of gross margins is closed with the company saying:

“Generally, we expect larger government contracts in our total revenue mix from third and fourth quarters. And as such, we anticipate the total gross margin will rebound in the second half of 2009. We are also confident that the gross margins can improve in each of our revenue segments in the second half of 2009.”

Government margins buoying the corporate sector margins is only a temporary solution, but if margins indeed improve in all revenue seconds in the third and fourth quarters of 2009, China Security & Surveillance shareholders could stand to profit handsomely.

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