UTStarcom(UTSI)stock price: 8.24shares out: 120Mmarket cap: 989MBUSINESSUTSI is a telecom equipment supplier that began in the 90s and came to prominence in the early 2000's because of its' success in selling PAS in China. PAS is a cheap wireless technology that piggybacks on a wireline system and is part of the traditional wireline companies' offerings in China. It gained quick popularity there because it costs significantly less than the second generation wireless systems it competes with. The founder, Hong Lu, is a native of Taiwan and the company's mission has always been to bring communication technology to the developing world. UTSI is an American company however but has most of its' workforce in China; the corporate office is in Alameda, CA. It also has as a core philosophy to base all its' products on an IP platform. So in a nutshell the idea here is to take advantage of cheaper engineering and labor from China, develop innovative products primarily for the developing world and take advantage of the convergence of broadband and wireless on an IP base.Now here in 2005 the company is no longer just a China PAS company. It has three divisions; Wireless(W), Broadband(BB) and Handsets(HS). The first two are infrastrucure and the Handset division is helpful to divide up into PAS HS and what I call ACC which began as an acquisition of a division of Audiovox last year. The company refers to the HS division as PCD and sometimes they include all handsets in that and sometimes they are just talking about the ACC handsets. It is important to seperate these handsets because ACC essentially is just a reseller of cellphones and they get about a 4-4.5% gross margin and they represent about 40% of the current revenue. These ACC sales are mostly in North America to carriers like Sprint and Verizon. They bought ACC to help them get in the door at these large wireless customers and also to have a channel to sell their own designs and builds into in the future. The PAS HS part is just that - UTSI designs, manufactures, distributes and it represents about 17% of total revenue. W is mostly China PAS and represents about 19% of revenue and BB are mostly products sold to Japan Telecom and represent about 21% of revenue. So far they have not diversified there customer or product base very well but they have many cutting edge technologies that have been in development for years but that have not reached a significant revenue level yet. FINANCIALSThe company grew its' revenue at an astonishing rate(smack dab in the middle of the largest telecom depression in history) achieving about $2B in sales in 2003. This was mostly organic growth but they had also made some strategic acquisitions in those early years. Then in 2004 they made the ACC acquisition which itself was doing about $1B in sales. This acquisition was at the end of the year and represented less than $300M of the $2.7B in company revenue in 2004, so they had about 20% organic growth in 2004 as well but it was clear that growth was slowing quite rapidly and now in the miidle of 2005 we know for sure that all of PAS revenue will be much smaller this year than last. Total revenue this year will probably be around $3.3B which if your following me so far doesn't really amount to any growth because the ACC piece by itself with no growth will add about $700M to 2005 revenues. In fact what we are seeing in 2005 is strong BB revenue, strong ACC revenue and weak W and PAS HS revenue. Not only is PAS down but the newer W technologies have just not sold well.Gross margin(GM) has been a real key to watch with UTSI. In the early years they had GMs in the 30's but as PAS competition heated up the company GM fell into the 20's. The W and BB divisions have the best margins and naturally the more cutting edge the products the higher the GM. PAS HS margins perhaps felt the pressure more than any other piece as they fell from the low 20s to about 12%. Now with the ACC division the total company GM this year has been about 21% and that really overstates the real figure because the first quarter had a bunch of high margin BB in it. They have apparently hit bottom in the first half of 2005 however as there was encouraging news across the board during the recent earnings call. Assuming some small improvements and the revenue mix staying on course, they should achieve a total company GM of about 20% this year.Unfortunately throughout all of last year and into this year UTSI was spending money like they were already that $10B company that they like to talk about. Operating expenses as well as capital expenses were way out of control and they have had some negative earnings because of it. When they started running out of cash and lies to tell they decided perhaps a restructuring was in order. They have chopped some heads and continue to fight their internal controls. The impact to the income statement is suppose to be $40M fewer in quarterly operating expenses by Q4. If this happens they will actually show a profit for the year excluding amortization of intangibles and restructurring charges. The other part of the restructuring is taking out in excess of $200M in working capital from the Balance Sheet by the end of the year. They got off to a good start with $82M in Q2 and were actually cashflow from operations positive in the quarter of $44M. The Balance Sheet has about $250M of net debt including a bunch of converts with about $1B of tangible equity.In summary, I believe the company is improving its' financials. In Q2 they improved gross margins, have shown progress in restructuring expenses, converted some working capital to cash and have a nice backlog of orders going into the second half. It is imperative to note however this is just one quarter and UTSI has a history of making things sound good for just one quarter when in reality things are awful. It will take many quarters and probably years of proper guidance and honest reporting before they could hope to regain some credibility regarding their financial reporting.VALUATION The company currently trades at less than book value, even tangible book value. They have a serious credibility problem with Wallstreet and they deserve it as last year was nothing but one lie after another about orders and new markets and inventory at customers and subsidiary dealings and it goes on and on. I do believe they are trying to get back into good graces with the street and that their current financials are probably fairly accurate. During their hypergrowth phase I think management lost all control of projections and supply chain and they are just now getting a handle on things. So if we take their numbers as accurate first of all I don't see a real liquidity crisis which is the main bear arguement(they are just going to run out of money). Even if they do a half assed job of cutting their working capital, it will still probably mean another $50-75M they can use to offset restructuring charges and further operating losses. I don't see a pressing need to even tap more of their credit lines much less go through them. Second, all indications are they will be profittable in Q4 mainly because of a large BB order but also because the restructuring savings should be in full effect by then. If they "get in" any deeper it probably won't happen until next year and by then I think we will be warned by paying close attention to how the restructuring objectives are being accomplished.So I simply feel that a company in this business with the kind of technology they have developed does not deserve to trade less than book and about a third of sales even if they aren't making money(which I think they will) or growing at all(which they aren't this year but the future still looks good). For some detail please refer to prior post.RISKSThere are many risks here. China is a big one as they still rely on their core PAS customers and are hopeful of using those relationships to ensure growth in the years ahead. I don't think PAS is going away anytime soon as there simply is not a cheaper alternative for the price sensitive China consumer. Regarding future non PAS China revenue there is the risk that the government won't allow UTSI to participate and will favor their own companies. I think the risk that there will not be massive spending on telecom networks in China in the future is almost nill.There is technology risk. I think the old familiar story about superior technology not neccessarily leading to superior sales applies to UTSI. We have already seen this with their TDCDMA products in many areas of the world. Regulators will side with legacy suppliers to keep newcomers out even if it means adopting inferior technology. Dishonest accounting is a risk here. They have been cited as having internal control problems. They also delayed filing their 10k and I for one thought they played way too many games with their numbers last year.Failure to restructure could be a problem. If they don't achieve their targets watch out. Management can't afford to screw that up. Furthermore, management has a lot of rebuilding of trust to do and there are legitimate concerns that Lu will not relinquish control enough for the company to ever get it together. CONCLUSIONSI think it is a good investment here because the company is not near as bad off as the stock market believes. It probably isn't even going to have a loss this year; nor did it last year. As long as the restructuring continues this better condition will become apparent to Wallstreet and the price will go north. Furthermore even though a lot of risks are present the reward of a big payoff more than makes up for them. Both China and Japan are at the beginning of huge multi-year investments that UTSI is well positioned to participate. Even if they never become a North American/European player I think they have good growth prospects.-Jim
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