China Fire & Security Group (CFSG)

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http://www.studio531.com/PressReleases/20070628_CFSG.pdf for full report, below is first part only.

Equity Research
Chinese Consumer,
Media and Technology
Published by Susquehanna Financial Group, LLLP, Member NASD


Thursday, June 28, 2007
China Fire & Security Group, Inc. (CFSG: $6.45, Positive)
Initiating Coverage with a Positive Rating
Adele L. Mao - 212-514-4772 - [e-mail]
Jie Liu - 212-514-4895 - [e-mail]


We are initiating coverage on China Fire & Security with a Positive rating. CFSG is a leading supplier of fire safety products in China's industrial fire safety market, with core competency in the iron and steel industry. As China continues to enforce its fire safety regulations in key industrial segments, we estimate that CFSG is poised to achieve annual top-line growth of 40%+, with sustainable profit margins in the next couple of years. In our view, CFSG presents a unique opportunity for investors looking to participate in an emerging, high-growth niche in China's industrialization.
HIGHLIGHTS
· Growing demand for fire safety products, driven by the implementation of fire safety standards in China. Based on recent statistics, the overall fire safety market in China is approximately $4 billion, and is expected to grow ~15% annually in the next five years. While opportunities abound, competition in China's fire safety market has been fierce. We estimate there are 16,000+ companies involved in various capacities as manufacturers, distributors, and project contractors. To a large extent, the growth of China's fire safety industry depends on the enforcement of China's fire safety regulations. With increasing public awareness for fire safety, we are seeing demand shifting from "mandatory" to "voluntary" for high-quality products. Positive Factor

· Niche industrial focus circumvents over-heated competition in residential and commercial segments. The industrial fire safety segment, with a current market size of approximately $1 billion, requires technical expertise and has higher barriers of entry. It is estimated that ~80% of China's industrial plants are not compliant with government fire safety requirements. CFSG is a leader in the industrial segment, enjoying an attractive gross margin of ~50%, compared to the industry average at less than 20%. Positive Factor

· Proprietary technology, cost-effective solutions, and more importantly, deep roots in a heavily relationship-driven industry. CFSG has a strong 30-member R&D team, and the company is expected to grow its R&D personnel by 50% in the next two years. Furthermore, senior executives have been actively involved with the establishment of fire safety codes and industry/product standards in and outside of China. CFSG's close involvement in regulation and standard-setting organizations provides the company with opportunities to steer policies/standards to its advantage, and establish a solid reputation among existing and potential customers. With CFSG's involvement, China's linear heat detector (LHD) standard is more stringent than the Underwriters Laboratories (UL) standard widely followed by international players, and this prohibits international LHD suppliers from competing for new projects due to non-compliance. Positive Factor

· We believe near-term positive catalysts should push valuation higher. 1) New contracts from existing key customers in the iron and steel industry, as major factories continue to modernize their facilities; 2) penetration into other industrial segments, i.e., transportation and tunnels, as well public venues, such as stadiums and theatres; 3) improving liquidity with near-term listing transition to the NASDAQ; and 4) strategic alliance with international OEMs, which presents immediate opportunities in China, and long-term opportunities in the export market. Positive Factor

· Substantial accounts receivables on the balance sheet, but so far, so good. CFSG's key customers are primarily state-owned enterprises, which often times delay payments, creating substantial accounts receivable for CFSG. For 2006, accounts receivable net of allowances accounted for 40%+ of total revenue. Typically, CFSG charges the customers 10-30% of the contract amount up-front, and collects the balance as the project progresses. While management is proactively seeking to reduce accounts receivable risks, we do not believe there is much room for improvement on the collection front, as CFSG has no choice but to compromise on payment delays in order to maintain long-term customer relationships. That said, write-offs in the industrial segment appear more manageable overall than in the residential/commercial segment, and in the case of CFSG, write-offs have been minimal in the past. Neutral Factor

· Valuation. Despite the 95%+ appreciation since CFSG's reverse merger in October 2006, we expect CFSG shares continue to appreciate over time, as the company delivers earnings growth and gains visibility among investors. At 13.8x our 2007 EPS estimate of $0.47 (+65% Y/Y), and 10.5x our 2008 EPS estimate of $0.62 (+32% Y/Y), CFSG shares are trading at a significant discount relative to its near-term earnings growth potential as well as market opportunities in the long run. We believe further upside in the shares will be driven by P/E multiple expansion, as well as upside to current estimates. In our view, management's "make-good" target of $13 million in net income and EPS of $0.46 for the year 2007 appear conservative, and we expect the company to beat the target with additional contract wins from existing and new customers, as well as with strategic alliances with international OEMs.

CONTRA CASE
Risks to our investment thesis include: 1) weaker than expected demand of fire safety products due to a lack of enforcement of new and existing fire safety codes; 2) China's economy slows down and causes domestic power, petrochemical, and iron and steel industries to contract; 3) new or alternative technologies introduced by competitors that are superior to CFSG's solutions; 4) penetration of new market segments takes longer than expected to ramp up; and 5) departure of any senior executives.
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SFG employs the following rating system:
Positive: The data points compiled and the analysis conducted by the research analyst sum up or "net" out to an overall positive view. This is not a net positive for the company, but a net positive for the stock, meaning the information and analysis contained in the report are not reflected in the current stock price and could reasonably be expected to have a positive or appreciating effect (when widely available to the public) on the current stock price.
Neutral: The data points compiled and the analysis conducted by the research analyst sum up or "net" out to an overall neutral view. This is not a net neutral for the company, but a net neutral for the stock, meaning the information and analysis contained in the report are either NOT reflected in the current stock price and could reasonably be expected to have no effect (when widely available to the public) on the current stock price, OR the information contained in the note is already reflected in the current stock price.
Negative: The data points compiled and the analysis conducted by the research analyst sum up or "net" out to an overall negative view. This is not a net negative for the company, but a net negative for the stock, meaning the information and analysis contained in the report are NOT reflected in the current stock price and could reasonably be expected to have a negative or depreciating effect (when widely available to the public) on the current stock price.

Prior to May 2, 2005 SFG employed a rating system as follows:
Net Positive which carried the same definition as Positive above
Net Neutral which carried the same definition as Neutral above
Net Negative which carried the same definition as Negative above

SFG Fundamental Research: 170 companies under coverage (as of 3-31-2007)

Covered companies in each rating category

Positive (Buy): 49% (83 securities)
Neutral (Hold): 49% (84 securities)
Negative (Sell): 2% (3 securities)

Investment banking clients in each rating category

Positive (Buy): 1% (1 security)
Neutral (Hold): 1% (1 security)
Negative (Sell): 0% (0 securities)

From January, 2006 to June, 2006 SFG used the following ranking system in addition to the above:
SIG Q SCORE(tm) is a hybrid quantitative modeling tool designed to cover a broad universe of stocks. It compares multi-factor analysis of historical, company reported financials and other quantitative trading and performance data to derive a ranking designed to provide a relative performance tool. The end result is a composite rank from 1 to 5 with 5 indicating the highest predicted return. The ranking is meant to be regarded as an indicator of relative performance. Based on these rankings, we would expect stocks ranked 5 to outperform those ranked 4 or lower over the next 12 months, those ranked 4 to outperform those ranked 3 or lower, and so on. The entire universe of analyzed stocks (of which SFG Small-Cap coverage is a subset) is divided into fifths, such that the percentage of stocks in each category will remain largely consistent over time. Changes in quantitative and other factors that occur after the ranking are not reflected until the model is run again next quarter.

Beginning July, 2006 SFG changed the ranking system to include only three SIG Q SCORE rankings from 1 to 3, with a SIG Q SCORE of 1 representing the highest ranking. The methodology of computing the rankings remains as above; however, the result is now divided into thirds rather than fifths and the order inverts with 1 now being the highest ranking.

SFG Small-Cap Research: 30 companies under coverage (as of 3-31-2007)

Covered companies in each rating category

SIG Q SCORE 1 (Buy): 27% (8 securities)
SIG Q SCORE 2 (Hold): 46% (14 securities)
SIG Q SCORE 3 (Sell): 27% (8 securities)

Investment banking clients in each rating category

SIG Q SCORE 1 (Buy): 0% (0 securities)
SIG Q SCORE 2 (Hold): 0% (0 securities)
SIG Q SCORE 3 (Sell): 0% (0 securities)

The qualifier reference to the term "Factor" (i.e., positive, neutral, negative) pertains only to the factor(s) that is the subject of the reference and is not meant to be an overall assessment or analysis of the company or the valuation of any of the company's securities. This release only provides selective information that may affect the company and should not be construed as a recommendation to purchase, sell or hold any security or to engage in any particular trading strategy. Investors should use the information contained herein in conjunction with other information they may have about the company to formulate their own investment and/or trading decisions and strategies.