Telestone Technologies (NASDAQ:TSTC)

This morning Telestone Technologies, announced its first U.S. contract:

"its Wireless Fiber Optic Distribution System (WFDS(TM)) has been selected as the local access network technology application for installation at a Houston hospital. The project will be installed by a U.S. firm, Quell Corporation, who won the contract after successfully demonstrating Telestone's WFDS(TM) functionality to the hospital and other major U.S. telecommunication companies."

This development is significant, as it indicates that the company is having success penetrating the U.S. market, which is a key element of its business plan. 

TSTC is one of the few ChinaHybrids stocks that has performed nicely over the past few weeks.  The company is currently on our "Tier Two" stock selection list 

Just three days after our research update on TSTC, the company issued a release updating guidance, it addressed one of our highlighted road blocks:

No net income guidance.

TSTC, maybe a response to our update, has now issued net income guidance of $22.9 million. This works out to EPS of $2.17 if we apply the 2010 first quarter fully diluted share count 10.5 million shares. 2010 analyst estimates are currently calling for EPS of $1.70.  The company also reaffirmed 2010 revenue guidance of $129.4 million.

"Demand for our proprietary, high-margin WFDS(TM) product line has accelerated as a result of Beijing's January directives to unify the delivery of telecommunication networks, TV networks, broadband data and internet access systems," stated Han Daqing. "The installation process for our WFDS(TM) business is more efficient than our traditional projects and requires less resources and working capital. We expect this to be a catalyst for both growth and margin expansion in the second half of this year and estimate that WFDS(TM) will represent at least 30% of total revenues for 2010. As a result of strong orders and improved visibility, we are reaffirming our revenue guidance of $129.4 million for 2010 and our previously stated gross margin guidance of 42%."

Since this development occurred after the conclusion of the 2010 second quarter, it may also bode well for the 2010 second quarter EPS results. Please note that since TSTC did not issue EPS guidance it could still be implied that the company may plan to entertain a financing before years end.

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: $9.06

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 some 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 accounts 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. Currency valuation:

"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 of the adequacy of the company's capital position 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?

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 stereotype that is being applied to these 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 and enact shareholder friendly moves. Credibility can also be restored if independent legal/SEC opinions validate accounting practices currently in question.

***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. 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.