Description
UTStarcom, Inc. (UTSI) designs, manufactures, and installs telecommunications equipment. The company provides end-to-end solutions (network infrastructure, consumer premises equipment, handsets) across a variety of wireless and broadband technologies. The company’s 0.875% 2008 converts ($400mm issue) currently sell for 64 cents on the dollar, with roughly $1.5bn of hard asset value covering the $400mm face value of the paper. The converts have traded down as a result of a confluence of factors, some fundamental and some technical, but I believe that there is a very high likelihood of full recovery as the company has ample liquidity and a reasonable plan to return to predictable profitability in the near-term. Full recovery from current levels would yield an 18% IRR to maturity, but a much higher potential IRR if any number of potential near-term catalysts play out.
UTSI’s product lineup is broad, incorporating numerous wireless (PAS, WCDMA, TD-CDMA, 3G) and broadband (DSLAM, GEPON, TVoIP) technologies. The company’s product lineup is fairly complex, but there are several general themes to be aware of. First, although the company’s product lineup appears to be somewhat confusing on an initial pass, it is unified by an underlying reliance on IP-based softswitch technology. Switches serve as the backbone of any network and, in practical terms, the company’s software-based switch technology is preferable to traditional copper-based switched networks since it provides much more cost-efficient scalability. The IP-based nature of the product lineup, moreover, gives customers the ability to generate multiple revenue streams (voice, video, data) over the same network, as compared to single-use traditional networks. The second important theme to be aware of is that the company’s historical financial track record has been built on the back of PAS technology. PAS is a relatively low cost alternative to more traditional wireless technologies, and has been the dominant wireless technology rolled out in China over the last several years. UTSI tripled its revenue base between 2002 and 2004, in large part due to its 55-60% share in PAS network infrastructure, and 50% PAS handset share, in China. This success, however, has been a double-edged sword. With 90% of its historical revenue base in China, and the PAS network build out now largely complete, UTSI is facing significant deterioration in its PAS-related revenue over the next couple of years. The company expects PAS-related revenues to drop by 40-50% this year from the $2bn it booked in 2004. This decline has been more precipitous than management originally expected, and has left the company in the interim with a bloated expense base.
Due to its overwhelming revenue reliance on PAS sales, UTSI’s numerous other technology initiatives have largely been overlooked. Through a combination of acquisition and internal development, however, the company has been quietly building an impressive lineup of alternate wireless and broadband infrastructure products. These products, which generated roughly $400mm in revenue in 2004, will more than double that to in excess of $1bn of revenue this year (UTSI had $600mm of backlog in these product lines at EOY 2004, and roughly 75% of the backlog typically burns off within a 6-month period). So, while the transition away from PAS is a rocky one, I believe that there are ample revenue streams to replace the PAS revenue and continue the company’s top line growth moving forward. Moreover, the diversification is quickly reducing UTSI’s reliance on the Chinese market. After generating roughly 80% of its revenue in China during 2004, the company generated 75% of its revenue in Q1 2005 outside of China. This is a huge shift that has been undertaken with impressive speed.
Another potential revenue elephant awaits on the UTSI sidelines as well. Part of the reason for the drop-off in PAS revenue in China is that the carriers are awaiting the award of 3G licenses. Until the timing on 3G implementation becomes clear, carriers have been scaling back the build out of their PAS networks (hence the decline in UTSI’s PAS revenues). If 3G license implementation gets accelerated, it is likely that carriers will scale down PAS build out as 3G eventually takes over as the dominant technology. If this happens, UTSI is well positioned to grab major 3G contracts. As the dominant providers of wireless infrastructure in China to-date, and one of four finalists in the 3G infrastructure approval process, the revenue potential for 3G infrastructure equipment is multiples of what was spent on the PAS build out. Moreover, given the fungible nature of UTSI’s softswitch technology, its presence as the current incumbent in Chinese wireless networks gives it an inherent advantage. If 3G implementation is delayed further it is possible that PAS spending once again reaccelerates. PAS continues to add users at a significant clip (an additional 6mm users came onto PAS networks in China in 1Q 2005 on a base of 70mm), and networks are reportedly running at 80% capacity (75% is typically considered full-loaded). Without alternate (i.e. 3G) networks to support the rapid user growth, network operators will be forced to continue expanding PAS network capacity.
Why do the converts trade where they do? Several reasons:
Sentiment. UTSI has been a short-sellers dream. The company is covered by virtually every short service due to its reliance on PAS and high levels of concern over the company’s working capital. As PAS has declined more quickly than management initially expected, the company has had to significantly ratchet back 2005 guidance on several occasions (both top and bottom line). Several quarters ago, management quit providing forward year guidance and elected to only provide guidance one quarter forward. Although the company posted 1Q 2005 numbers well ahead of virtually everybody’s expectations, its guidance for a material operating loss in 2Q 2005 was a major negative surprise. Current reported short interest on the equity is roughly 15% of the float, but there is unconfirmed speculation that, despite the implementation of SEC regulation SHO, there are very high levels of stock sold short for which no locate has been obtained (and which therefore are not accounted for in the reported short interest numbers). The sell-side has turned uniformly against the company, and it would be difficult for general sentiment to be more negative.
Recent adverse operating cash flow. UTSI is a working capital pig. In large part due to its historical reliance in China, and the associated lengthy payment cycles there, receivables have demonstrated an ugly trend over the last couple of years. Despite this, UTSI has historically generated positive operating cash flow even during its most aggressive growth years. In both 4Q 2004 and 1Q 2005, however, operating cash flow began to run negative. This drove the company from a net cash position to a net debt position and, I believe, was largely responsible for the violent reaction in the converts following the recent earnings release. Investors are extrapolating the recent cash flow trends, and are running scared that a major liquidity crisis looms. I think this is unlikely, and represents a lack of understanding of the drivers behind the negative operating cash flow in the two most recent quarters. In 4Q 2004, UTSI closed on the purchase of Audiovox’s handset distribution business. The business was purchased without receivables and, as a result, UTSI had to make a material working capital investment to bring the receivables up to a reasonable run-rate during the quarter. In 1Q 2005, the operating cash flow deficit was due primarily to the $150mm drawdown of a customer advance. The advance had been related to a controversial marketing program that UTSI was running for a related party, Japan Telecom, and despite extensive disclosure regarding the contract and expected cash flows in the company’s prior SEC filings, the size of the drawdown clearly took the market by surprise. UTSI’s revenue guidance for 2Q 2005 ($740mm vs. $890mm in 1Q) actually holds a silver lining with respect to liquidity. Given the business’ high working capital requirements, I believe that the revenue drawdown could potentially free up as much as $150mm in operating cash flow from working capital in the current quarter. Management has targeted $200mm in specific working capital reductions by year-end under a business plan that contemplates growth in run-rate revenue, so in my mind there is significant potential for cash generation thru improved working capital management even if management falls well short of its goals. UTSI has ample additional liquidity, as well, with roughly $600mm of availability on its revolvers. Revolver availability, as an aside, was increased by nearly $175mm in April, so the company’s banks (who are privy to more detailed operating projections than public investors) clearly buy into the business plan. UTSI’s recent aggressive moves outside the Chinese market should bode well for working capital needs going forward as well, as payment cycles tend to be materially better on a relative basis outside the Chinese market.
Technical. Recent difficulties by convert arb funds have been well covered. Numerous funds are facing significant redemptions, and liquidity is paramount. In this environment, I believe that many funds are shooting first, asking questions later, and taking advantage of liquidity where they can find it. The UTSI converts typically trade a couple of million bonds a day; on the day following the company’s 1Q earnings announcement over $100mm bonds traded. The converts traded down roughly in the line with the equity (30-35%), which is surprising given the vastly superior asset coverage. Remaining holders of the converts are heavily hedged on the equity, and there are a significant number of convert traders who were actually shorting the bonds in the 60-62 level. This adds up to extremely heavy potential buying pressure given even a modest change in either financial performance or sentiment.
There are a couple of ways to look at valuation on the UTSI converts:
Balance sheet – UTSI currently has $2.8bn of assets (excludes goodwill and intangibles), $2.4bn of which are current. $2.1bn of the $2.4bn in current assets are represented by cash, liquid investments, receivables and inventories (i.e. assets which can be converted to cash at reasonable conversion rates). Despite high inventory balances, I see little material risk in this line item. Network infrastructure equipment is built to contract (i.e. not on spec assuming future sale), and handset inventories turn relatively rapidly. There are $1.3bn of current liabilities in front of the converts. As such, there is $1.5bn of asset value (excluding goodwill and intangibles) covering a $400mm obligation. Even under conservative liquidation assumptions (i.e. A/Rs and inventories @ 75%, PP&E @ 35%, deferred tax assets @ 0%, all liabilities at 100%), I reach a current net asset value of $600mm covering the $400mm obligation (at face value) – implying that the company can burn thru $200mm in operating losses to reach a full recovery at face for the converts, or roughly $350mm to reach full recovery at current cost. As mentioned above, I don’t believe that liquidity is an issue given the company’s borrowing capacity and likely improvements in working capital management.
Income statement – In 2003 UTSI generated roughly $2/shr in EPS on a revenue base of $2bn. This year, I expect the company to generate $3.5bn in revenue (down from original company guidance last year of >$4bn in 2005 revs), however, neither current run-rate revenues nor historical operating margins are a good proxy for the company going forward for several reasons: 1) PAS revenues continue to decline rapidly, 2) the 2004 purchase of Audiovox’s handset distribution business added roughly $1.5bn in run-rate revenue which comes in at very low (4-5%) gross margin, and 3) aggressive price competition in the Chinese market has had a material negative impact on equipment gross margins in that region. Management has initiated an aggressive restructuring plan which is targeting $160mm of run-rate operating expense cost cuts to come out by year-end 2005. Due to the many moving parts, I am using 2006 as a more reliable proxy for what the base earning power of the business should be. My assumptions:
Revenues + gross margin:
$1300mm broadband and non-PAS wireless infrastructure @ 40% gross margin
$1500mm PCD/Audiovox handsets @ 7% gross margin
$120mm PAS infrastructure @ 30% gross margin
$260mm PAS handsets @ 11.5% gross margin
Total revs = $3200mm
Total GM = $690mm
Operating expenses = $530mm
Amortization = $10mm
Operating income = $150mm
Interest expense = $11mm
Pre-tax = $139mm
Net income = $101mm (27% tax rate)
EPS = $0.89/shr
A few notes on my assumptions:
- Broadband and non-PAS wireless revenues of $1300mm are up from roughly $1050mm in 2005. As mentioned previously, this line item has been growing rapidly – it was $400mm in 2004 and the company already had $600mm in backlog for these lines coming into 2005.
- Broadband and non-PAS wireless gross margins of 40% are below both current run-rate and management guidance.
- PCD/Audiovox handset gross margins ramp up from current 4.5% level due to higher % of UTSI-designed product (which carries 20% gross margins) running thru the distribution channels – this ability to run in-house product thru distribution channels was a major rationale for the acquisition.
- $400mm of aggregate PAS infrastructure and handset revenue could prove conservative, as could gross margins on the PAS business as this low level of revenues would imply true maintenance-only status for the business and virtually no new development overhead.
- Management’s target operating margin is 8-10% - well above the 5% that I am projecting (for detail see the company’s recent analyst day presentation posted on the company’s website).
Clearly, if you can get comfortable with a growing $0.90/shr earnings base the converts are money-good and the common equity has even more kick; however, for reasons listed previously I believe the converts provide nearly as much near-term upside, with much better downside protection than the equity. Pick your flavor.
Risks:
Company proves unable to continue recent positive momentum in broadband equipment sales; inability to achieve announced cost cuts; continued deterioration of operating cash flow; material write-down of receivables
Catalyst
Generation of positive operating cash flow in 2Q – liquidity fears subside; return to operating profitability; award of China 3G contracts; tail on PAS equipment and handset sales proves longer than expected; award of other Tier 1 carrier contracts; announcement of repurchase of converts by company