Finding insecurity in BlueStar SecuTech

Rarer than the Chinese Crested Tern

Such is my ignorance of banking in China, before writing this blog I had to check the yuan is the Chinese unit of account, like the pound is the UK’s, and renminbi is the currency, like sterling. So let’s talk yuan, and whether BlueStar SecuTech (BSST), a manufacturer of digital video recorders and supplier of security systems to Chinese banks is going to make The Thrifty 30 any pounds.

According to the company’s prospectus [pdf], the document issued to institutional investors during the company’s placing in 2007, Chinese bank video surveillance systems must be replaced every five years to prevent obsolescence. China, is, as we all know by now, a big market, and although there are many other indigenous DVR manufacturers, at the time of its IPO BlueStar supplied 18 of the 25 biggest banks, including four of the big five.

It’s in a juicy sounding business, it’s been profitable since its flotation, and pays a dividend, so it’s surprising to find it languishing with French Connection in the current list of Ultimate Bargain Stocks.

This screen uses the most exacting measure of value, demanding a company’s shares cost less than the per-share value of its most liquid assets less all its liabilities, and insisting the company scores highly for financial strength, an unlikely combination. The market values BlueStar at just 74% of its net current assets and the company scores seven out of nine using Piotroski’s F_Score. It’s as rare as a Chinese Crested Tern.

After a difficult year ending in March 2009, which the company blamed on delayed orders due to the global financial crisis, it seems to be growing again. It’s diversifying into whole systems, and services, and eyeing up opportunities in defence.

But value investing is all about gauging risk, and it’s much easier if the risk is quantifiable.

It’s the unquantifiable risks that make me nervous.

China’s biggest lender and a customer of BlueStar, the Agricultural Bank of China, recently listed in Hong Kong and Shanghai. It was the last of the big Chinese banks to go partly public, and its sheer size, with 320m retail customers, 27,000 branches and $1trillion in deposits indicates, perhaps, the opportunities BlueStar is expecting to exploit.

The bank’s history does little to dispel my unsophisticated impression that Chinese banks are riddled with corruption, inefficiency, bad debt, and state interference.

Admittedly things may be changing, but banks owe BlueStar about 176m yuan (£17m), more than its market capitalisation, for security systems it has supplied and is awaiting payment. Chinese banks are, according to the company’s annual report, slow payers.

That £17m is 64% of BlueStar’s current assets (the rest is mostly cash), the same current assets I’ve counted in deciding the shares are cheap. If a customer didn’t, for some reason, pay, the company wouldn’t look so cheap.

More likely BlueStar’s growth will be limited because its having to finance its customers. This year net operating cash flow (cash profit) was just £6m compared to net profit of £31m. Last year the company made a loss in cash terms. The discrepancy exists because profits are booked when companies make a sale, but cash is credited to its bank account when the customer pays. BlueStar use up funds to manufacture and distribute new equipment while it awaits payment for systems it’s already sold.

At its current price BlueStar would still be a good investment if profits remained flat, but it’s not going in the Thrifty 30 because it’s incorporated in the British Virgin Islands. It’s not subject to UK company law or the Takeover Code which ensures that all shareholders are treated equally. Without the code, a bidder can buy shares at a premium from some shareholders, without other shareholders even knowing.

Since a takeover is one of the ways the value in BlueStar could be realised, I’d want to be sure the Thrifty 30 would get its share.

BlueStar’s articles of association provide some of the protection the code does, and also give shareholders pre-emption rights, which are not required under BVI Law, but the articles can be changed by a 75% vote.

Bearing in mind the company’s ceo, Mr Xiao, owns 42% of the shares, and major shareholders own 88%, I’m not sure how reassuring this is.

Its third biggest shareholder, Mackenzie Cundill Investment Management, a fund manager with a “deep value” investing style, presumably, sees the value and is comfortable with the risks. But value investors don’t seek security in other people’s actions, and even though deep value usually trumps other considerations, I see insecurity in BlueStar.

It’s incorporated in a country which affords shareholders fewer rights, it’s listed on our less rigorously regulated stockmarket, AIM, and it operates entirely in a very competitive market in a country about which I know very little. Despite the compelling numbers, the combination is too exotic for the Thrifty 30.

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