China Wind Systems (NASDAQ:CWS)

Added to the GeoBargain list on December 9, 2009 @ $4.40

Catalyst: Appeared to be on the cusp of strong EPS growth; Operates in an industry segment that the Chinese Government will promote.

Peak performance: Reached a high of $8.20 on January 1, 2010

Current Price:$4.36

Current road block: A capital raise seems likely, especially since the company has issued 2010 net income guidance with no EPS guidance and has filed an S-3 to potentially offer stock; Dealing with some internal control issues.

Again, our hands are tied. How should investors approach a bullish story when EPS growth is the unknown? CWS reported 2009 EPS of $0.34.

For the 2010 first quarter CWS reported net income and EPS of $1.9 million and $0.08, respectively.

Based on a 2010 adjusted net income guidance range of $15.5 million and $16.3 million, CWS is expecting to report around $14.0 million for the remaining nine months of 2010. This works out to about $0.55 ($0.18 per quarter) using the 2010 first quarter's share count of 25.4 million. CWS reported adjusted net income of $5.9 million for the last nine months of 2009 or EPS of $0.29.

We have taken this information and calculated what we call the dilution threshold, or how much stock a firm could issue while still achieving EPS growth of at least 30.0% in each of the next three quarters. In the case of CWS, it could issue around an additional 26.0% more shares (~6.6 millon) and still achieve at least 30% quarterly EPS growth. Complicating the matter is that CWS still has 3.97 million shares of deep-in-the-money warrants outstanding, yet to be exercised. Investors who choose to take an ultra conservative stance, by considering the warrants, would attain a dilution threshold of ~10.4% more shares (~2.63 million). (We are speculating that given the recent market uncertainty, some investors may have chosen to exercise their warrants).

Ultimately, it may be prudent not to be overly aggressive until more clarity is provided on the amount of shares CWS may offer in the future. Although, given the dilution threshold, the story seems strong enough to warrant some exposure, especially as no shares have yet been issued, which bodes well for the June 2010 quarter and will increase the threshold.  We were able to confirm that 2010 guidance does not include a capital raise assumption. Also, analyst net income estimates are below the company's guidance, implying that we could be in store for EPS upside surprises. (The Brean Murray 2010 EPS estimate is $0.42).

CWS will likely tap the equity markets:

"In connection with our expansion project for our business, we will incur significant capital and operational expenses. We do not presently have any funding commitments other than our present credit arrangements which we do not believe is sufficient to enable us to satisfy our purchase commitments and to otherwise complete our second expansion project for our business. If we are unable to obtain necessary capital to pay our purchase commitments and we cannot find alternative financing we may be unable to complete the next phase of our expansion or finance the growth of our existing business, which may impair our ability to operate profitably. During 2009 and the first two months of 2010 we raised approximately $5.4 million from the private sale of our debt and equity securities, including the exercise of outstanding warrants, in a number of transactions. A significant portion of the funds were raised on terms which we did not consider favorable."

The fact that CWS's cash flow ratio and cash ratio, discussed below, are less than one also supports this assumption.

Our intent over the short-term is to build a check list to assess the risk position of firms in the ChinaHybrid space. For the time being this will consist of the following: (this list is likely to grow substantially)

- Is the company's auditor ranked in the top 100?
- Is the auditor located in the USA? If located in China the PCAOB (Public Company Oversight Board) may be denied access to investigate the practices of the auditing firm. Short sellers have been using this information as a tool to validate their opinions.
- Are the company's internal controls satisfactory?
- Are their any outstanding legal issues?
- Do the company's top ten customers represent less than 10% of revenues?
- Operating cash flow divided by current liabilities is greater than one. The higher the better. (we will use annualized cash flow run rate and eliminate non-cash charges from account liabilities ).
- Cash divided by Current Liabilities is greater than one. This is the most conservative liquidity ratio.
- Is the company buying back stock?

GeoTeam® Note:

Please note: On July 6, 2010, the GeoTeam® removed all Chinese stocks that were on GeoBargains and GeoSpecial lists to respective Radar lists as we complete our "quality assessment."

Short term and risk adverse investors should be aware of the quality issues currently present in the ChinaHybrid Space, questioning the validity of what seem like solid fundamental stories. It is beginning to get ugly so be cautious and understand that more pain may have to be endured, as ChinaHybrids are easy prey for short investors. The broad brush that is being applied to theses stocks appears unfair, but we can’t ignore the psychological impact this can have on investors' portfolio decisions. If history is our guide, fear will eventually create an immense opportunity to invest in the companies that prove they can meet quality litmus tests enact shareholder friendly moves. Credibility can also be restored if independent legal/SEC opinions validate accounting practices currently in question. 

***Very Important GeoTeam® note. We have yet to verify if the Chinese filings for ChinaHybrid stocks we monitor match respective SEC filings. We are in the process of completing this task. Although we are not totally convinced that SAIC filings are an accurate represenation of financial statements the issue is impacting stock prices. Conservative investors may want to limit exposure or buy put options on stocks, that have this availability, as insurance against long positions, until we publish our findings. Odds are we will identify some promising companies that will fail this litmus test.

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