Telestone Technologies (NASDAQ:TSTC)

¹Added to the GeoBargain list on September 24, 2009 @ $6.42
Removed from the GeoBargain list on January 6, 2010 @ $24.40
²Added to the GeoBargain list on February 8, 2010@ $15.36

Catalyst: Strong EPS growth was on the horizon; Account receivable position was improving; Bullish guidance.

¹Peak performance: Reached a high of $24.94 on January 1, 2010

²Peak performance: Reached a high of $22.20 on February 23, 2010

Current Price: $8.00

Current road block: Internal control issues; Weak account receivable position; Cash and operating cash flow position do not cover current liabilities; Dilution door is open; No net income or EPS guidance; Short investors have "attacked" TSTC.

TSTC shares have been on a wild ride within the last 12 months, eclipsing $20.00 in January 2010 and once again in February 2010 after a brief pull back. We are happy to see that TSTC has finally received analyst coverage from Roth Capital who is forecasting EPS to grow 41.1% to $1.70 in 2010 followed by 51.2% to $2.57 in 2011.

Investors must be keenly aware of a few issues:

1. Dilution: In March 2010, TSTC filed a form s-3 leaving the door open for an offering. This will weigh on investors minds and likely limit TSTC appreciation potential until more clarity on this issue is received. The fact that Roth Capital has picked up coverage also could lead some to believe that a raise may be imminent.

2. The high account receivable position is still present.  Part of the reason for the stock's initial rise was probably due to an improved AR position and comments from management of expectations of continued improvement. Management has informed investors that a high AR position is the nature of its business, where payment terms are determined by a few major customers:

"We experience a longer accounts receivable turnover period than our main competitors due to our revenue being generated from a higher mix of system integration projects, which are typically billed in phases throughout the life of the project. We believe that our main competitors are more focused on equipment sales, which tend to have shorter receivable turnover periods. Generally, we and our main competitors have traditionally experienced a longer receivable turnover period due to the fact that our main customers are the three state-owned telecommunications carriers, which tend to make payments slower. Additionally, approximately 10% of our professional services revenue are settled after 24 months of our warranty period. We have not experienced any significant bad debts in the past."

Still, a high AR standing is a psychological barrier for investors and could increase the need for a capital raise since it could be postulated that money would not be available in a timely manner to expand operations.

3.  "The value of the Renminbi against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in the PRC’s political and economic conditions. Any significant revaluation of the Renminbi may materially and adversely affect our cash flows, revenues and financial condition. For example, to the extent that we need to convert U.S. dollars we receive from this offering of our common stock into Renminbi for our operations, appreciation of the Renminbi against the U.S. dollar could have a material adverse effect on our business, financial condition and results of operations. Conversely, if we decide to convert our Renminbi into U.S. dollars for the purpose of making payments for dividends on our common shares or for other business purposes and the U.S. dollar appreciates against the Renminbi, the U.S. dollar equivalent of the Renminbi we convert would be reduced. Any significant devaluation of Renminbi may reduce our operation costs in U.S. dollars but may also reduce our earnings in U.S. dollars. In addition, the depreciation of significant U.S. dollar denominated assets could result in a charge to our income statement and a reduction in the value of these assets."

4. We have followed the TSTC story for sometime and have witnessed that the company has missed guidance in the past. This is possibly why the company may have stopped issuing net income guidance.

Riskier investors may be able to contend with the above issues, given the company’s low valuation. Investors need to inquire if the company is generating enough cash flow to satisfy an “increase in sizeable orders for new projects using our WFDS(TM) solutions, notably for two major installations in Inner Mongolia and Sichuan.”

"We will need to increase our investment in our technology infrastructure, facilities and other areas of operations, in particular our product development, in order to facilitate our growth. If we are unable to manage our growth and expansion effectively, the quality of our products and services, and in turn, our customer support, could deteriorate and our business and results of operations may suffer."

Liquidity:

We are unsure of TSTC's plan to tap the equity market as it did not adequately address capital needs in the 2010 first quarter filing. (Liquidity and Capital Resources section was scant). We find this unacceptable. Liquidity sections typically include a statement stating if the the company's capital position is adequate for the next twelve months.  We are speculating that the need to raise money may be a priority for the company.

Although its cash balance stands at $10.0 million, its cash flow from operations for the 2010 first quarter was negative $1.1 million. In order to derive a final conclusion on liquidity needs investors would need to gain clarity on TSTC's 2010 and 2011 capital expenditure plans.

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 U.S.A? 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?
- Annualized Operating cash flow divided by current liabilities is greater than one. The higher the better. (We will adjust current liabilities for non-cash items).

- Cash divided by current liabilities is greater than one. This is the most conservative liquidity ratio. The higher the better.

- Is the company buying back stock?

Criteria	Meets Criteria	Notes
Top 100 Auditor	YES; member of the Praxity alliance which ranks among the top 10 of international accounting firms	Mazars CPA Limited
Auditor located in the U.S.A	NO	Hong Kong
Satisfactory Internal Controls	No	Based on this evaluation, our principal executive officer and principal financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were not effective due to the fact that the material weaknesses in the Company’s internal control over financial reporting described in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2009 have not been remediated as of Evaluation Date, although steps have been taken toward remediation during the quarter ended March 31, 2010.
No Legal issues	Yes	None Found
Customer Concentration	No	2 customers accounted for 90% of the Company’s total operating revenues as the 2010 first quarter. All of our agreements with our customers are for short term projects or sales of equipment.
Cash Flow Ration is Greater than 1	NO	Negative
Cash Ratio is Greater than 1	NO	.20
Buying Back Stock/Insider Buying	NO	n/a

GeoTeam Note:

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.

Telestone Technologies reported improved first 2010 quarter financial results yesterday evening.

	Q1 2010	Q1 2009	% Change
Net Sales	$11.1 M	$7.9 M	41.0%
Gross Profit	$4.9 M	$4.7 M	5.10%
GAAP Net Income	-$1.1 M	$1.1 M	-199%
Non-GAAP Adjusted Net Income	$1.5 M	$1.1 M	28.3%
Non-GAAP Adjusted EPS	$0.14	$0.11	26.6%

The company exceeded analyst EPS estimates of $0.12.

The bad news is that the DSO (Days Sales Outstanding, or receivables still not collected expressed in days) figure of 673 days might appear out of control to many investors.  Part of the attractiveness of the TSTC story had been that management was bringing the DSO number down.  The company also had negative a cash flow position for the first quarter.

We feel that this situation increases the possibly of  yet another equity raise in the China space.

Add to this, the company's guidance includes a laundry list of assumptions that may not ease investors' minds.

• Continued ability to sign contracts and complete installations in a timely manner
• A favorable macroeconomic environment in China
• The Company's expectation that integration of telecommunications, TV & radio broadcasting and internet access networks in China will begin in 2010 and the government will continue to support these measures
• The Company's belief that its advanced technology and production capabilities along with strong R&D capability will provide a clear differentiation in a competitive market
• The Company's ability to increase sales of it higher margin WFDS(TM) system throughout the year
• Sales execution from the four new branch sales offices
• Successful strategic marketing cooperation with Huawei Technologies Corp will continue to build a solid foundation for future market expansion, especially for overseas market development, and domestic market expansion

We don't want to be short sighted, but in the current market environment conservative investors may want to take extra care when considering an investment in TSTC. Quality is of the prime importance right now.

We will maintain the the GeoBargain code due to strong analyst EPS estimates of $1.93,  but conservative investors may want to look elsewhere until the picture becomes clearer. Also, please note that the estimates likely do not include dilution from an equity raise.

TSTC has been on the GeoBargain list twice:

Thursday, September 24, 2009 - GeoTeam completes interview with Telestone Technologies (NASDAQ:TSTC). Company coded as a GeoBargain at $6.42.

• Reached  a high of $24.94 on January 26, 2010
• Removed from the GeoBargain list on Wednesday, January 6, 2010 @ 24.94

After January's market pull back we added TSTC back to the GeoBargain list.

Monday, February 8, 2010 - GeoTeam places Telestone Technologies (NASDAQ:TSTC) back on the GeoBargain list at $15.36 due to recent pullback, guidance reaffirmations and improvements in accounts receivable issues.

• Reached a high of $22.20 on February 23, 2010
• Current price: $10.75

It has been a wild ride for Telestone Technologies over the last few months. We initially coded the stock as a GeoBargain on September 29, 2009 @ $7.00.  Three months later the stock eclipsed $24.00, where we decided to remove it form the GeoBargain list as it attained a premium P/E.  As January 2010 rolled in, TSTC shares tumbled along with the rest of the market. So, we decided to double dip and place the stock back on the GeoBargain list at $15.36, after which shares briefly rallied over $20.00.  The stock is now back below $15.36, despite posting a strong finish to the 2009 year and EPS numbers that exceeded our target in GeoInvesting's initial TSTC article.

December Year	Fully Year 2009	Fully Year 2008	Period Change
GAAP Revenue	$71.9 million	$35.3 million	103.7%
GAAP EPS	$1.21	$0.68	77.9%
Fully Diluted Shares	10,404,550	10,436,128	0.0%

Source: 2010 10K Filing

Possible Reasons for weakness:

• Investors may have been expecting a larger EPS number, although we are not sure why (We are speculating that investors used pre-tax margins instead of net margins to back out a net income figure from 2009 revenue guidance).
• The company guidance was bullish, but non specific with regards to net income, despite being well into the first quarter.
• A pessimistic investor was on the conference call.
• An equity offering is likely looming on the horizon.

We may nibble down here, but investors need to be aware that this company has had a history of choppy quarters, which has stung the GeoTeam on several occasions.

On Thursday, Sept 24, 2009 the GeoTeam took a "field trip" to Center City Philadelphia to meet the Management of Telestone Technologies Corporation (NASDAQ:TSTC). We left the meeting feeling good about increasing our position of the stock in our portfolio. The meeting prompted us to label the stock a GeoBargain that day at a price of $6.42.

Telestone provides 2G and 3G wireless communication access coverage solutions to telecom companies such as China Mobile (NYSE:CHL), China Telecom (NYSE:CHA) and China Unicom (NYSE:CHU) through its branch offices in China across 26 provinces. In general, the Company:

• Develops wireless, IP, CATV access network unification solutions technologies (WFDS^TM) that are proprietary for carriers or building owners for their local information access network
• Designs and manufactures telecommunication equipment used in its access network systems or sold directly to other telecom vendors.
• Implements its access solutions by installing the network systems at client sites through its nationwide branch offices.

Key Considerations:

• The Chinese government will spend $70 billion over next 3 years on 3G initiatives. This creates both visibility and acceleration in TSTC's business.
• TSTC has aggressive goals over the next two and a half years to increase its domestic market share from 5% to 33%, indicating that it intends to capture a good deal of government-allotted spending with its new WFDS^TM technology.
• International business accounts for less than 5% of TSTC revenues. TSTC plans to expand its operations in the US and other developed markets with its WFDS^TM technologies, while serving those that are underdeveloped and behind the technology curve with its mature 2G technology to extend the life cycle of its 2G products.
• TSTC has issued 2009 guidance of $70 million in revenues, up 100% YOY. Based on its 2009 first half performance we assume TSTC can minimally maintain 17% net-margins, implying an EPS figure of $1.14. (15% tax rate assumption). Our EPS assumption is likely conservative as Telestone's annual after tax margins are typically around 20%.

New Proprietary Technology Could Become the Industry Standard

Telestone can address a multitude of wireless and all types fixed cable lines needs including those associated with security, phone, TV and computer applications with this new technology. Before 2009, these needs were addressed with separate solutions resulting in higher costs and less efficiency, exacerbated by architectural constraints.

The Company tackled this dilemma in 2008 and 2009 when it launched its WFDS^TM technology.

"As an all-optic network, WFDS^TM combines the technologies of ROF (radio over fiber) and its proprietary system components to transmit all kinds of information feeds into a building. This system supports all mobile telecom networks and a variety of other networks including WLAN, FTTH, telephone networks, and video surveillance systems. The benefits of the technology are substantial cost savings over old technologies, low loss in information transmission, easy and quick installation, low intrusion to the construction and minimal maintenance."

In simple terms, the WFDS^TM platform allows all aspects of a client's wireless and wired needs to be addressed as one comprehensive solution. WFDS^TM has become more significant since China began granting third generation (3G) licenses during the first half of 2009. 3G systems put greater technical demands on the communication networks in buildings due to signal strength and frequency- demands that WFDS^TM can handle much more effectively than traditional wired and wireless methods.

WFDS^TM Gaining Traction

• Currently, TSTC is the only Chinese company offering a WFDS^TM type platform. Even as competition enters the market, Telestone has a significant advantage because customers will likely be hesitant to switch to another provider with unproven reliability.
• Telestone believes that customers will gravitate to its services as the advantages it offers have the huge potential to save time and money;

Telestone's Hurdles

As we followed the Telestone story for a couple of years, we witnessed the stock's peaks and valleys. However, it appears that the Company finally has an opportunity to take a nice leap to the next level of growth - an opportunity which we feel was hampered by the delayed launch of 3G in China, ultimately forcing customers to postpone spending.

With the 3G launch out of the way, it appears that one more hurdle is impeding Telestone's progress. The Company has been experiencing accounts receivable collection delays as a result of multiple factors including timing of CAPEX and effective live network dates in addition to massive industry consolidation which occurred during the past year to create the Big 3 Providers of today. However, the company anticipates that this situation will improve going forward:

"During the 2009 2nd quarter reporting period account receivable turnover has improved by nearly 30% when compared to the 1st quarter of 2009."

"While we believe having a good long-term relationship with our clients is very important, we will spend additional efforts on collecting accounts receivables, and expect to perform well in the next half of 2009."

With the formal launch of 3G and an improving accounts receivable outlook, investors may begin take notice of TSTC, especially since the stock is selling at only 7 times our implied 2009 conservative EPS guidance, has no long-term debt and sports a book value per share of $5.35.

Associated Investment Risks

Apart from the nature of the business which may lend to inconsistent quarterly results, there are a few issues that you should consider when investing in TSTC.

• As discussed above, Telestone's accounts receivable position continues to be an issue, and even more so when combined with the Company's high accounts payable standing. The problem is exacerbated if accounts payable becomes due prior to the Company's ability to collect cash from operations or ability to collect receivables. As the company accelerates growth it will need working capital.
  
  Per Telestone's 2009 2nd quarter filing operating cash flow is negative, although it balances annually. We are hopeful that increasing sales and improved collections will resolve this issue.
  
  
• Investors should also be aware that there is a certain level of business risk when dealing with Telestone's integration of its business plan into international markets.
• Finally, Telestone needs annual certification in order to bid on new business, albeit a requirement that has never posed a problem for the Company.

Disclosure: The GeoTeam is Long TSTC