China Fire Misses, Trims Guidance

China Fire & Security Group Inc. (CFSG) reported earnings per share of 26 cents in its second quarter ended June 30, 2010, falling short of the Zacks Consensus Estimate of 28 cents and 30 cents in the year-ago quarter. EPS was hurt by lower-than-expected revenues, lower gross margins and higher operating expenses.

Both the current quarter and year-ago quarter’s EPS excluded non-cash option and restricted stock expenses. Including the same, China Fire reported EPS of 22 cents compared with 29 cents in the year-ago quarter.

Total revenue increased marginally 0.4% year-over-year to $22.8 million, but missed the Zacks Consensus Estimate of $28 million. The Maintenance services segment was the only segment posting a growth of 55% to reach $1 million in revenues. System contracting projects dipped 0.1% to $18.3 million, and revenues from residential roofing products further stooped 6% to $3.5 million. Both the segments suffered due to the slowdown in the execution of projects from the iron and steel industry, a derivative of lower steel selling prices and rising costs of iron ore.

China Fire’s backlog as of June 30, 2010 was $145 million, an improvement of $4 million from the end of the first quarter of 2010.

Cost & Margin Performance

Cost of revenues rose 27% to $10.4 million in the quarter. Based on revenues, the same increased to 45.7% from 36.2% in the year-ago quarter. Consequently, gross profit fell 15% to $12.4 million and gross margin plunged to 54.3% from 63.8% in the year-ago quarter.

Operating expenses hiked 10% to $5.4 million in the reported quarter and based on revenues, it soared 210 basis points to 23.8%. The increase in expenses was mainly driven by a surge in general and administrative expenses and depreciation and amortization expenses. Operating income declined 27% to $7 million and operating margin plunged to 31% from 42% in the year-earlier quarter. Lower gross margins and higher operating expenses led to the decline in operating income and margin.

Financial Position

As of June 30, 2010, China Fire had cash and cash equivalents of $27.8 million, up from $25.1 million as of March 31, 2010. During the quarter, China Fire generated operating cash flows of $2.8 million compared with $400,000 in the prior-year quarter

Outlook

China Fire’s revenues were hurt by lower steel selling prices and rising costs of iron ore. Further, its major clients in the iron and steel industry are facing a difficult time due to the weakness in the housing industries. Based on current backlog and contract pipeline and current setback within China’s iron and steel industry, China Fire trimmed its fiscal 2010 guidance.

Revenues are expected to be within the range of $118 million to $125 million, down from its previous range of $135 million to $145 million. The revised guidance implies a growth rate of 45%-54% over fiscal 2009 levels.

Net income is now estimated in the range of $34 million to $36 million, down from the previous range of $47 million to $49 million. The EPS target range is now $1.20 - $1.26, substantially down from its previous range of $1.65 - $1.70.

Our Take

China’s Iron & Steel Industry's Revitalization Scheme promotes total production control, encourages industry consolidations and emphasizes the development of new technologies. This stimulus plan provides financial subsidies and loan discounts to leading iron & steel companies, thereby enabling advanced steel producers to upgrade existing plants and build new ground-breaking facilities. Given that China Fire derives a dominant portion of its total revenue from the iron and steel industry, it stands to benefit from such upgrades.

A major amendment of the Fire Prevention Law issued on May 1, 2009, requires all fire protection products to comply with the national standards. Nearly 80% of steel plants are not fully compliant with new mandatory fire safety requirements. Given the strong support from the government, China’s massive iron and steel industry will likely accelerate the process of upgrading the outdated fire safety systems. Given China Fire’s dominant brand position, it is strategically positioned to capitalize on the emerging growth opportunities in this market.

China Fire primarily serves the iron and steel, power and petrochemical industries, and relies heavily on the iron and steel industries for its revenues. Though the company is now exploring other industrial sectors, we believe its inability to successfully expand the market for its products and services in these industries will limit its long-term growth potential. Thus, we maintain our long-term Neutral recommendation on China Fire.

China Fire & Security Group, through its wholly owned subsidiary, Sureland Industrial Fire Safety Limited, is engaged primarily in the design, manufacturing, sales and maintenance services of a broad product portfolio including detectors, controllers and fire extinguishers. China Fire’s clientele comprise major companies in iron and steel, power, petrochemical and transportation industries throughout China.

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