Description

Ulticom (ULCM) $8.90

A simple special situation investment.

Ulticom is a casualty of the backdating-options scandals and the downfall of its majority owner, Comverse Technology.  The company has a stable niche business selling SS7 software to telecom OEMs such as Alcatel and Siemens.  The stock has fallen under $9.00 since Ulticom’s delisting, and the company now trades at a low multiple of earnings.  There is a very good opportunity here for someone to buy the business, drastically cut R&D, poach the large cash balance and milk the core Signalware product line for cash.      

Background:

Ulticom is a New Jersey based provider of network software.  The company was known as DGM&S Telecom and was purchased by Comverse in the 1990s.  Comverse took the company public in 2000, and currently holds about 68% of the shares outstanding.  Ulticom’s core product line is Signalware, which is a bundled SS7 software/hardware package.    

SS7 is Signaling System #7, which is a collection of telephony signaling protocols that allows various telecom networks to exchange information.  So when you make a phone call, SS7 is used to deliver and route your calls.  Techies might not like this description, but it’s sort of the language that allows call services for fixed and mobile calls.  Here’s a description from Ulticom’s website:

“Signaling System Number 7 (SS7) is a sophisticated, integrated signaling protocol designed to increase the efficiency of telephone service delivery. It has become the central nervous system for the delivery of wireline and wireless, and more recently IP services, the latest step in the convergence of communication networks. All networks need signaling to create connections, activate service, and deliver traffic.”

Ulticom’s main product includes the Signalware software and an interface board which is physically connected to networks.  The revenue from deploying these SS7 boxes is essentially a one-time fee as there is no recurring maintenance charge.  The lifecycle of the boxes depends on their particular use, but the company says 5 years is typical.  They enable services such as voice and text messaging, video messagine, payment services (post-paid and prepaid – this is Ulticom’s largest source of revenue now), basic switching, and mobility services (roaming, authentication).  Customers include Ericsson, Nokia, Alcatel-Lucent, Fujitsu and Sonus.  As there is little maintenance revenue, continued industry growth is the key to the stability of EBIT going forward.  

Is this a very crappy business?

In some ways, it seems like Ulticom’s business is essentially building commodity boxes for powerful OEM’s like Siemens and Alcatel, who are rapidly consolidating.  Indeed, Ulticom’s strongest competitive threat comes from OEM’s who take their SS7 solutions in-house.  On the other hand, the company’s gross margins have been stable for years and there is only one other significant competitor in the outsourced space.  Ulticom has a 25% market share, HP has 20% and in-house solutions have about 50%.  Additionally, HP and Ulticom are not really competing SS7 solutions.  HP provides SS7 solutions on its own network platform and Ulticom is part of a Sun Microsystems platform. 

While OEM consolidation has hurt Ulticom sales in the short-term – both Alcatel and Siemens have held back on spending ahead of their respective mergers - the company views industry consolidation as a long-term positive.  In the end, Ulticom does difficult, labor-intensive programming that must navigate interactions between various country-specific SS7 standards.  Ulticom has a decent little niche here that is not going away any time soon.

I don’t think the market recognizes the quality of Ulticom’s business.  A lot of attention has been paid to Comverse and its solid server business as well as Verint, which has a fantastic security software portfolio with true growth potential.  Ulticom is the smallest, most overlooked actor in the Kobi Alexander drama. 

Valuation:

Ulticom has a $380mm market cap and a $281mm cash balance.  In peak years, Ulticom has earned EBIT close to $20mm.  Average EBIT from 2000 through the last audited EBIT in 2005 (which included the 2002 telecom spending bust) was around $10mm, which included about $10mm per year in R&D expenses, most of which was in new product development. 

Since the Comverse options-backdating scandal, Ulticom has not provided audited financials.  Instead, they disclose sales on a quarterly basis as well as a few other figures (cash balance, legal costs related to audit and investigations, capex).  Sales have been down (to $59mm over the LTM versus just over $60mm in 2004 and 2005) and the company has guided that there has been some margin pressure from large customers.  While earnings have not been disclosed, the company continues to spend heavily on R&D developing new products unrelated to Signalware and the cash balance keeps steadily growing.  The company recent sales have been soft in part because two of its largest customers, Siemens and Nokia, consolidated and delayed spending on Ulticom-related projects.  The company expects this to be a temporary pause in spending and expects revenues from Nokia-Siemens to pick up over the last half of this year.   

Over the last twelve months, Ulticom has increased its cash balance by about $8mm in cash.  Interest income was probably somewhere around $11mm.  Legal expenses have been high (up to $1.2mm a quarter) and the company continues to invest R&D dollars into its new Nsignia product line.  While the company has not guided its level of R&D except to say that they have increased it, we can assume it’s somewhere over $10mm per year. 

I know this valuation discussion has been convoluted, but the main points are:

-          Ulticom has a huge cash balance and a cash-flow positive mature business valued at $100mm

-          Signalware, the core business, generates average EBIT somewhere around $17.5mm if you back out R&D spending on new products.  Peak years are closer to $27.5mm

-          Even during a very rough year where two large customers have delayed spending on Ulticom projects and the company is enduring various audits and investigations, Signalware EBIT is probably around $10mm.  

Historically, Comverse has been very conservative in its control of Ulticom and has prevented the company from making acquisitions with its large cash balance.  Now that it appears Comverse is out to sell itself and its subsidiaries, Ulticom is officially for sale and there is little risk Comverse will let it make a dumb acquisition before finding a buyer.  A buyer like Sun Microsystems could pay $10 or $11 bucks a share for Ulticom (valuing core biz at $150mm-$200mm), tuck Signalware into its line of products, drastically cut R&D and other costs and keep the cash balance for itself.               

Catalyst