A Much Needed Litmus Test for ChinaHybrids

We need to address investors' concerns who have viewed the GeoTeam position on Chinese stocks as bearish.

We believe it for prudent for us to inform short term and risk adverse investors of the quality issues currently present in the ChinaHybrid Space.  It is no secret that investors have been questioning the validity of what seem like solid fundamental stories, a situation that has caused ChinaHybrids to be easy prey for short traders. The broad stereotype that is being applied to these stocks appears unfair, but we can't ignore the psychological impact this can have on 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. In the end this gut check could make the sector stronger and more inviting to a wider of array of investors. The question is not if China is cheap...we all agree it is. The question is more about the health (quality perception) of our China space and how long it will take before the issue is mitigated. It will just be a matter of time before value wins out for the quality firms. 

To be clear, we have not removed our support for the China Space. We have supported it for 6 years. But we will remove our support for stocks that disregard shareholder needs. The key is to find the quality stocks that will emerge from the wreckage and portray a real commitment to increasing shareholder value. We are clearly bullish on this quest, as many solid companies have been unfairly punished. Overall, we will focus on shareholder friendly stocks where "controversy" is minimal, as they have similar valuations as the ones that embody controversy.(very unique situation). We are beginning to witness firms who are adhering to the  "shareholder maximization" concept by enacting share buy back programs and insider buying moves. Investors who can look past the short term and into the 2010 4th qtr and 2011 will likely be rewarded by making calculated gambles in this sector. It happens all the time. We will lose some soldiers, but be are left with Generals.

As mentioned in a previous post, we have looked at over 50 ChinaHybrid firms. We are searching for companies with solid capital and auditing structures who have expressed no need to tap the equity markets.

New Energy Systems Group (OTC BB:NEWN), China Mediaexpress Holdin (NASDAQ:CCME) and Deer Consumer Products (NASDAQ:DEER) that may fit this bill.

Shareholder Friendly:

• All three of these companies have issued bullish guidance and have shown a strong commitment to shareholders. DEER has a 20 million share buy back program in place while some minor insider buying transactions have taken place at CCME. 
• All three have expressed an ability to grow business without having to access the capital markets.

Auditors:

• All three engage top ten auditors. NEWN has actually issued EPS guidance, a rare occurrence in the ChinaHybrid space.

Points to ponder:

CCME

• In light of recent events in the ChinaHybrid space we would prefer that CCME's auditors be located in the U.S.A.
• Uncertainty over the need to obtain an advertising license in certain jurisdictions.(We will gain more clarity on this issue).

DEER

• We would like to gain an idea on when the company will become cash flow positive.
• Ownership structure issues may exist.

NEWN

• We are curious as to what accounted for NEWN's lack of internal controls findings highlighted in its March 31, 2010 quarter after claiming no such problems in its 2009 year end 10K.

The following is a format we will often utilize as explore companies in the ChinaHybrid space (this example is for NEWN):

Current road block: Internal control issues; Investors may proceed with caution due to China's recent pledge to allow its currency to appreciate against the dollar and the Euro. This could lead some investors to insinuate that such a move could hurt international revenues.

NEWN believes it finally meets the corporate governance requirements to list on a senior U.S., something investors had been eagerly anticipating. Unfortunately, this news came at a time of market turmoil. By taking its time, the company had missed a golden opportunity to see its shares rise when the market was "hot". Regardless, this news combined with strong EPS guidance makes NEWN a strong story. Furthermore, management has stated that it does not foresee a need for outside capital in the near term.

As for currency risk:

• We have yet to know how aggressive China will enforce its policy.
• NEWN guidance does not assume a large contribution from international efforts.
• Most of their sales are currently in China, so shouldn’t have a major impact.

Liquidity appears intact:

The company’s cash flow from operations is tracking at an annual run rate of $26.4 million, while its cash position currently stands at $8.5 million.

Press release comments:

"We are well positioned to capitalize on this demand due to our reputation for producing high quality and innovative products. We continue to generate strong free cash flow, have a solid balance sheet, and have unused manufacturing capacity, which will allow us to continue growing without incurring significant capital expenditures."

Quality Check:

See similar assessments for CCME and DEER.

***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.  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.

Positions: Long NEWN, DEER & CCME at time of this post

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