China Techfaith Wireless (NASDAQ:CNTF)

On October 15, 2010, we issued an alert that we established a small position in China Techfaith Wireless @ $4.00.

As part of our diversification strategy, we are attempting to identify Chinese companies that may be able to avoid fraud "debates" initiated by short investors. Investing in once high profile ADR/ADS IPOs may be a way to approach this task.

In general, we have had little success investing in stocks similar to CNTF - those companies that design and manufacture private label cell phones sold to PRC and international OEM customers who offered products to the end customer.

Other ChinaHybrids that were in either the cell phone design or accessory business include faltering reverse merger firms T-Bay Holdings (OTC BB:TBYH) and Orsus Xelent Technologies (NYSE AMEX:ORS). Both of these companies never delivered sustained results. In fact, TBYH was the first pump and dump company we had encountered in the ChinaHybrid space. However, PRC based reverse merger firm Sinohub (NYSE AMEX:SIHI) claims to be making progress tackling this market by targeting demographics the big boys do not want.  On the U.S. side Forward Industries, Inc. (NASDAQ:FORD) made a few fleeting attempts to entice investors' appetites.

CNTF completed its initial public offering in May 2005 at around $16.00. Lackluster profit growth since its IPO led to a precipitous decline in its stock price to a low of $0.73 in November 2008.

The company's main revenue source was hit with a perfect storm of unfortunate circumstances.  Despite the high margins of its original design phone business (ODP), as evidenced by the 2005 data, opportunities did not materialize as expected.  The end result was a loss of customers and a deterioration in margins due the inability to cover expenses, something that its highly profitable segment was usually capable of.  CNTF also choose not to dramatically cut it employee head count.

Approximate non-GAAP Pre-tax Margins History:

• 2009: 6.4%
• 2008: 2.4%.
• 2007: loss
• 2006: loss
• 2005: 49.1%

So Why Are Some Investors Excited?

In response to its new reality, the company realized it needed a fresh way to drive revenues and revive margins, eventually leading to a decision to introduce its own line of branded phones. CNTF believes that this move will allow it to capture higher margins by selling upper end products directly to the customer. A heavy emphasis on smart phones also gives them exposure to an exploding market. We also learned that PRC consumers can use any carrier to activate their phones, thus creating market opportunities. The company will still maintain its private label business, but mainly for its international clients.

2009 20F Excerpts:

"In an effort to minimize the adverse effects of the global financial crisis and weakening economic conditions, we have strengthened our position through cooperation agreements with Beijing Huaqi Information Digital Technology Co., Ltd., or Beijing Huaqi, which owns “aigo”, a leading brand in consumer digital products market in China for the operator-tailored market in China, and with QIGI Technology for the smart phone business in China in 2008. These and similar strategic collaborations have helped and will continue to help promote our products in China and swiftly bring them to market. Under the strategic cooperation agreement with Beijing Huaqi, we will provide total solutions products, including CDMA1X/EVDO and UMTS/HSDPA, under the “aigo” brand name and through the sales channels of “aigo” for operator-tailored market in China."

"We put emphasis on the branding of our mobile handset products because branded products—especially products bearing well-known brands and images—offer a higher profit margin compared with other mobile handsets we sell. For instance, in the first quarter of 2010, we obtained control of QIGI Technology which becomes one of our variable interest entities. QIGI Technology is a company based in China and focused on the sale of smart phones. After the acquisition, QIGI Technology will operate largely independent of our existing operations; we intend to focus on promoting QIGI as an important Techfaith brand, with emphasis on QIGI brand smart phones."

"In February 2009, we launched, under the “aigo” brand name, nine new mobile phones designed specifically for the 3G network in China. The nine new models are from three different product lines which include dual mode GSM phones, modem card phones and DVDO phones. Of the five dual-mode GSM phones, three are WCDMA plus GSM phones designed for new China Unicom subscribers and two are CDMA plus GSM phones designed for China Telecom CDMA subscribers. There are two modem card phones, one of which utilizes a HSDPA modem card and the other uses an EVDO modem card. The final two models have GPS functionality and run on CDMA1X and EVDO. These nine different models cover CDMA1X, WCDMA, GSM and EVDO technologies and encompass a broad range of subscriber demands from the different telecom operators in China."

CNTF expects further growth from its 2008 entry into the mobile gaming business. Although this venture is not yet meaningful, it is expected to contribute to 2011 revenues.

"In 2008, we started to develop our online and mobile game business through One Net. One Net made significant progress in 2008, and set up Radiation studio, Star studio and Mythos studio to develop games. We also outsourced the development of online games to another independent studio and set up an in-house studio to design and develop mobile games. In 2009, we provided mobile game services and began to earn revenues in the fourth quarter of that year. We launched one MMORPG game in January 2010 and expect to launch more games during 2010. We expect an increasing portion of our revenues to come from this part of our business."

CNTF further believes that integrating mobile content into its phones will also increase the attractiveness to its commercial and retail customers.

So far, through the first nine months of 2010, financial results have begun to reap the benefits of restructuring efforts:

• Sales increased 26.2% to $195.0 million
• Adjusted earnings per ADS grew to $0.32 from $0.24.
• Adjusted pre-tax margins came in at 12.2%

Additional positives:

• Stock has held up in a challenging market 

• Sells below book value per share of $4.81

• Healthy cash per share of $3.70

• Entire company endorsing the company
  
  "China TechFaith Wireless Communication Technology Limited (Nasdaq: CNTF) ("TechFaith") today announced that 132 TechFaith employees, including directors and senior managers (the "Investors"), will invest a total of RMB 50 million in the company's games subsidiary, 798 Entertainment Limited. Mr. Defu Dong, Chairman and CEO of TechFaith and CEO of 798 Entertainment, said, "This investment reflects the high optimism and confidence our management team has in our games business strategy and future success. In addition, this direct investment in 798 Entertainment by our employees will further motivate our employees to achieve higher performance levels, as they will directly benefit from the success of 798 Entertainment."
  
• Investors show confidence:
  
  "IDG-Accel China Growth Fund II L.P. and IDG-Accel China Investors II L.P, holders of US$10 million aggregate principal amount of 8% senior secured convertible promissory notes issued by TechFaith's subsidiary Leo Technology Limited, now renamed 798 Entertainment Limited, in June 2009, have exercised their conversion rights under the Convertible Notes. Pursuant to the relevant investor rights agreement, each of the IDG Funds chose to convert 62.5% of its share of the principal amount of the Convertible Notes into TechFaith's ordinary shares, and the remaining 37.5% was converted into shares of 798 Entertainment Limited."
  
• Auditor: Deloitte Touche Tohmatsu

• Internal controls are in check

From our experience, the highest probability to capture gains with this type of story exists during the period of change, when a renewed focus leads to new sources growth. So, even if the plan fails long term, some investment gains can still be captured. But if growth continues as planned, maybe investors will assign a premium valuation to its shares on par with U.S. companies. Margins have a long way to go to approach historical levels which could lead to extended EPS gains as long as CNTF does not get dilution happy. Time will tell what the long-term future holds for CNTF, but given its current book value and cash per share, the story is worth tracking. The stock has a P/E of 8 on our expectations that it will report close to $0.50 for 2010. We still need to hammer out 2011 expectations.

Additional Considerations with the Help of GeoInvesting Member Rotobanco:

• Will CNTF now be competing against its OEM customers and will this impact relationships?

• Will there be an eventual patent infringement issue. The name of the new motion controller is 17wee.

• Why issue stock to buy Qigi? They had $120M in cash, their stock was selling in the 2 dollar range, and they bought the company with stock. The purchase price for QIGI was only $12.5M. So they could easily have paid cash. If the prior owners wanted stock in the new company that badly, they could have just bought it on the open market. Even more puzzling, the make good net income target for QIGI is $8M for 2010. Why did the owners sell this company for 1.56 times earnings with almost no cash in the deal?

• Due to the note conversion by IDG, CNTF will have an additional 6 million ADS shares outstanding.

• Bear in mind that they are a Chinese brand competing domestically. The Chinese consumers have choices such as Ericsson, Nokia, Apple, Blackberry. Why will they Choose "Qigi" in an environment where the Yuan is increasing in value, and higher-class foreign products are becoming cheaper in price.

• The existence of a $30 million convertible bond at 0.5% interest bond that converts at $5.00 anytime between now and 2015 could create some price resistance.  Note that it is with the government and the company has indicated it does not expect this to convert.

Short Q&A with management:

Q: From 2005 to 2009, there was an abrupt drop in earnings.

http://www.sec.gov/Archives/edgar/data/1316317/000114554907001176/h01318e20vf.htm

It appears that earnings still have not recovered to 2005 levels. What was the reason for that drop?

A: The main reason is because the market situation has changed from when we did a lot of design business which carries very high gross margins and in 2006 we lost our biggest customer (took up 70% of total revenues)- NEC which dropped the business in China. Overall, the design business from the big brand names were getting less and less.

Q: How much of the cell phones that you manufacture (both ODP and QIGI) end up in the hands of Chinese consumers as opposed to non-Chinese consumers?

A: From the revenues side: domestic market= 85.%; overseas market=15%

Q: In your power point from 1Q 2010, on page 13, the title says “QIGI – The Leading Smartphone Brand in China” Is that what your goal, or is that what is actually the situation right now? Is QIGI currently the leading smart phone brand in China?

A: It is our goal to be the leading brand in China. Currently, there are some resources to show that we are probably in the third place.

Q: You seem to carry a large cash balance. This has been true since the company went public. Does management plan to eventually deploy that cash balance? If so, how to they plan to deploy it?

A: The cash will strongly support our business future growth, such as for the ODP business cash flow for the smart phone business and our branded phone business. We may spend some of our cash on good potential M&A, marketing and sales activities. But we won't lower our cash position a lot.