Thursday, November 29, 2007

Recap of Q&A sessions from the shareholder meeting

Shareholder Meeting.

I attended the shareholder meeting today held at the Alameda corporate office. From management side, Hong Lu, Peter Blackmore and Fran Barton were the main speakers. Also in attendance were Susan Marsch (General Counsel), Thomas Toy (Director), other employees, and their auditors. Before I get into the details, I’d like to thank management for conducting a professional shareholder meeting, taking questions from shareholders during the Q&A portion and showing us their current line of products afterwards.

The initial part of the meeting dealt with administrative issues such as Thomas Toy’s nomination and confirmation as a Tier 1 director and reconfirming PriceWaterhouseCooper as their auditors. Then, Blackmore, Lu and Barton each took time to discuss the company business. I will skip their presentation for now as that is recorded and I can listen and summarize that at a later time. I want to move to the Q&A portion that was not accessible to the general public. The format for the Q&A portion was to have each shareholder have an opportunity to ask 1 question and if time permitted, additional questions would be taken. I think it was a good idea for them not to include this in the web-cast for the shareholder’s privacy and the unpredictability of the line of questioning and discussions. There were about 10 shareholders that attended, a few flying in from out of town and one from Mexico! There were no analysts present. I was working in San Francisco and took off from work in the afternoon to go across the Bay. I was concerned with the initial thought of the Q&A session being recorded because we may not have the opportunity to ask as many questions and again would be too unpredictable. That being said, I was also worried that frustrated shareholders would pull punches if it was recorded.

I’m pleased to report that the Q&A session was very candid, open, and sometimes heated starting with the initial question regarding the sale or lack of sale of Gemdale (only 10% has been sold). As you can imagine, each person had multiple questions and management did a good job in responding and moving it along. The questions included:

Why was only 10% of Gemdale holdings sold?
What is the average infra revenue per iptv subscriber deployment?
What are the available options to deal with the convertible bond?
Can you get financing in China?
Will they try to get financing in China or the US?
Why not cut costs further if most of the core technologies are already developed?
What were the details for the ML strategic study? Where there offers for the entire or part of the company?
Based on the current low share price and positive expectations by management for the future, would you consider share buybacks and/or insider purchases? (my question)
What valuation did the board have in mind (my follow up question to the ML discussion that I asked Mr. Toy– I got to ask two questions J and anything directly related to the stock price was applauded by the shareholders)
If iptv is positioned as the growth driver, why are the overall margins relatively low?
Can you clarify your opex to core revenue ratios and the potential core revenues in 2009?
Can you comment on the high short position?
Discussion on PAS revenues-packet data 128kbps (not sure if this was in the general discussion or Q&A)

After the formal Q&A session, they lead us to another room for a more informal one on one discussions and to show us their products. The group basically broke up into two separate groups of shareholders, one with Hong Lu and one with Fran Barton and Peter Blackmore. I spent my time with the 2nd group and had very open and candid discussions primarily with Fran Barton and a bit with Peter Blackmore. After the shareholder meeting, I met up with some of the other shareholders and discussed the meeting and compared notes for another half an hour or so. So, the entire event lasted a little over 3 hours for me. After the more formal Q&A session, the following items were discussed in the more informal session:

· PCD and its place within the company now and in the future
· OPEX- how it is currently bloated even with the planned cuts
· Lack of disclosure during the yearlong quiet period when financials were released
· Discussion on timing of the turnaround
· Why were the previous estimates from Barton so far off?
· Any updates on the recent BSNL tender for GEPON/WIMAX gear
· Info on the WiMax gear shown on their website. Potential market and position within their company in the future
· Updates on Japan revenue
· When will the new iptv Asian customer win be announced?
· Different handsets in the marketplace and if UT was involved with them
· Lu discussed the reasons for originally purchasing the PCD
· Lu discussed the iptv competitors and how their product compared to them
· Lu discussed his impression of the shorts. Someone asked Lu how they can break the shorts
· Lu discussed the impact of the Verizon’s decision on opening up their network
· Lu also discussed Japan ADSL and position of various operators in Japan
· Lu discussed their position as handset integrator for Verizon and others
· What are institutional reactions to the current share price?
· Selling or borrowing against the China building

There are probably more items discussed as I was only in one group and just heard part of Lu’s discussions with the other group.

So, what are my general takeaways from the shareholder meeting? The shareholders did not pull any punches making their frustrations, concerns, and suggestions known. To management’s credit they answered everyone’s questions and are well aware of all the shareholders concerns. Obviously, this was a very difficult environment with the stock price at $3. While I don’t agree with everything done in the past, I believe they are taking reasonable stapes at this stage to return the company to sustainable profitability. It’s a line and management position that we have heard plenty of times before (cutting costs, improving controls/efficiencies, waiting for market to grow, using partners, using OEMs, having great products, concern about shareholder value, etc). I had gone in thinking there was no good option at this juncture anyway so I would be in no matter what. Having talked with management, I have “hope’ that much better times are ahead and somehow things are different this time. Maybe, I’m a sucker for a happy ending. In the short term, not selling the Gemdale position may hurt the stock but it was going to be difficult to go against the bad stock technicals and at this late in the year anyway. The turnaround is not going to occur right away as we all know.

Some thoughts on Peter Blackmore, the future CEO of the company. I paid close attention during the Q&A portion and he was in agreement with the shareholder concerns and you could see him often nodding. I think he is very sharp, is the right person for getting the cost structure right and making UT very competitive on the cost side. I believe he understands the company assets and potential markets that UT has and can lead the company back to profitability and higher share prices. Obviously, this was a shareholder meeting and management has to be generally upbeat so we still need to track their progress and COMMITMENT to profitability.

As mentioned, I had more discussions with Fran Barton and thank him especially for his candidness and willing to engage the shareholders. As most know, I am not a techy like Tigre/Shadow so it was enjoyable to discuss the stock price, the way the street values UT, his previous and current estimates, etc. Ultimately, I hope they are able to better predict their business operations to make necessary changes to their cost basis and to better communicate with the street. Towards the end of the Q&A session, I specifically wanted to thank management for updating the shareholders and having all of those CC. I hope they continue and more importantly hope it will be under much better operational performances.

Wednesday, November 28, 2007

Zacks keeps sell rating and reduced price target to $3

Two days before the shareholder meeting and following S&Ps and BofAs $3.5 and $3 targets, Zacks reduces its 6-month price target to $3.

http://biz.yahoo.com/zacks/071127/10399.html?.v=1

The key reasons include:

1. Lack of business momentum and declining GMs.
2. Not expecting profits till 2010. Company financials do not reflect the anticipated synergies from the restructuring activities.
3. Possible default of convertibles.
4. No near term growth elements.

I agree with the near term profitability picture as losses of 41 and 28 cents are expected for Q4 and Q1 but I would disagree with the declining GMs (these are set to go up from 10 to 13% and improve in 2008), no profits till 2010, default on convertibles, and near term growth elements (need to check bookings and new wins). I do agree with the financials not reflecting the restructuring activities because these won't be felt until Q1.

Hopefully, the current low shareprice and reports like this will spur management to make significant structural changes and make tough choices that they have not done in the past. If so, then we can look at these months as the bottoming phase and look forward to the long-awaited turnaround.

Saturday, November 24, 2007

Letter to management

This is a letter that I will be sending to management ahead of the shareholder meeting.

Dear Sirs,

I have been a shareholder for the better part of the last three years and have been very disappointed with the company/stock performance to say the least. The recent filings show the continued losses in 2006 and 2007 but more importantly, the street has lost confidence in the company due to their lack of communication during these critical times, poor internal controls, bloated expense structure, and lack of visibility in the company’s businesses. The continued losses into 2008 and history of over-promising and under-delivering has weighed on the stock.

It is very difficult to stay positive in light of the current sub $3 share price and know it will take some time to turn this around. I do have some hope with the recent actions from the company such as (1) finishing the options/China investigations-filing the financials for the last 5 quarters, (2) reclassifying and selling long term holdings in Gemdale/Infinera, (3) being able to transfer funds from China, (4) identifying core/non-core operations, (5) cutting operating expenses to $115m/quarter, (6) seeking out cash flow efficiency savings, (7) monetizing the patent portfolio, (8) showing tractions in iptv/broadband, gepon, optical, surveillance and other new initiatives and (9) hopes for profitability in late 2008/early 2009.

I have recently started a web-blog at http://utstarcom-stocknews.blogspot.com. So far, it has generated about 600 visits in just the last 12 days. The purpose of the blog is to compile information about the company, share investor opinions, and hopefully provide a conduit between shareholders and management. One of the reasons I am writing now is to discuss topics in the upcoming shareholder meeting. Because the stock price is at historic lows right now, shareholders have many questions on the company’s future turnaround plans as well as previous decisions and results. Let me emphasize that as much as we’d all like to move on towards the future, we need to learn from the past. With the stock being where it is, it is apparent that the street is also not moving into the future yet. Most stock price targets are in the $3.5 range and continued significant losses are expected in 2008.

A few topics that I have put on a poll (in the web-blog) that management can hopefully give more color to in the shareholder meeting are the following:

-Details of the strategic options study with Merrill Lynch. Shareholders are very dissatisfied with the explanations and lack of details surrounding such a critical event in the company. Where there offers to buy the company? At what price? If not, what where the major issues? What where the attractive points and negative points? We shareholders can appreciate that some information cannot be disclosed but I am also sure you understand where we shareholders are coming from in light of the shareprice.
-Gemdale/Infinera sale. Updates regarding liquidity are very important during these credit tough times.
-PCD divestiture. Most shareholders did not buy into the company with the PCD in mind and are mostly in favor of divesting the PCD to solidify liquidity position and focus on core businesses. I can appreciate that you cannot divulge too much but anything towards the divestiture of this division will help the shareprice. For me, this was the symbolic move away from core goals of the company and would represent a symbolic re-focusing the goals of the company.
-Japan revenues. Shareholders have not heard much regarding Japan and the close ties with Softbank.
-Convertible Bond update.
-Share repurchase or insider buying. The low share price has to be addressed by management. Projections are great but the street is looking for tangible actions by the company/management.

-OPEX and growth of the Core businesses. There are major concerns that the target opex to core revenue ratios that management has given in the last cc will not be met anytime soon (even in early 2009 and be sustainable) and that opex should be cut further now rather than later. Updates to bookings and future plans are much needed to clarify confusion with this important goal. Aside from 3rd party projections, what do you see in the iptv/broadband markets that give you confidence in attaining these ratios? Otherwise, this is another example of over-promising and under-delivering.

I would like to end by stating I appreciate the updates from the company and hope that it continues. The last conference call presented a very good start to addressing the street concerns but results are needed. Because the turnaround will not occur overnight, shareholders need answers to a lot of questions and management can do much more to defend the share price right now. I am personally looking forward to meeting management during the shareholder meeting next week and hope to get some answers to share in the web-blog to fellow shareholders.

Thursday, November 22, 2007

IPTV in Korea/Vietnam-Next front for UTStarcom?

Thanks to Nawar for providing updates on Korea IPTV.

http://messages.finance.yahoo.com/Stocks_%28A_to_Z%29/Stocks_U/threadview?m=ts&bn=27187&tid=146476&mid=146476&tof=1&frt=2

http://malaysia.news.yahoo.com/rtrs/20071122/tbs-markets-korea-hot-b8dd11d.html

From the last CC,

"In particular the IPTV business continues to gain momentum. Attributively we have booked approximately 240 million in IPTV contracts and recognized approximately $80 million in revenue. We recently won new contracts in Fujian Province in China and a major new customer in another Asian country, which we can announce in a few weeks. We currently have IPTV deployments in China, Japan, India and Brazil. We have about half a million live IPTV subscribers and contracts for about 2 million subscriber system capacity.

We are not sure if Korea is the next deployment for UT. Some are speculating Vietnam but the growth of worldwide iptv acceptance is good for UT. The trends support explosive growth in iptv:

http://www.telecompaper.com/news/article.aspx?id=193418&nr=&type=&yr=

Wednesday, November 14, 2007

The bull case for longterm share price appreciation

Let me begin by saying that earnings the last 2 years have been bad and going to be bad in 2008 again. Just looking at the earnings estimates for 2008, analysts are expecting losses of $1.02/share. That is a frightening number when compared with the current stock price of $3.3. The street is waiting for the company to be profitable or at least be cash flow positive. Target prices are a fraction of book value. While this may seem reasonable and a reality of the current moment, this ignores the strategic position and assets the company has. For the past few months, I and others have added up liquid assets (cash, investments, and even the PCD) to size up the current situation and assess potential for a liquidity crisis that could negate any potential for a future turnaround. This was necessary because we did not have access to the financials, did not know whether the company was going to be sold/go private, did not know how quickly they would burn through cash, the impending convertible bond situation or the status of the current business itself.

Through the filing of 5 quarters of past results (Q3/Q4 of 2006, and Q1-Q3 of 2007) and update conference calls, I can say that I have never felt as confident about the turnaround as I have now. What turnaround am I talking about here? The share price going to $6, 10, 15, 20 or higher? No, the turnaround will be about discarding none-core assets, reducing bloated expenses and growing core revenues in the sectors and countries with explosive growth. Most of the long shareholders that bought 2 to 3 years ago had this in mind but circumstances and company mismanagement has moved away from this. Now, I can see the beginning of getting back to this situation/goal. Let me highlight some key developments recently:

-Separating the core and none-core business. The acquisition of the PCD division was the beginning of the downturn, moving away from their core goals/competency. It tried to cover up revenue loss from PAS and the company moved away from growth to a low margin company with losses and lost direction. Now, management has decided to realign the business units and separate the PCD division. Most shareholders have been talking about separating and selling the PCD for a long time now. On the last CC, Blackmore is basing target R&D and SG&A ratios to revenue that does not include the PCD. An analyst also asked about operating expenses for the PCD under the cover that the PCD is the largest revenue source for the company. However, this is really to value the PCD for sale in 2008, which even S&P concedes will probably happen.

-Growth drivers. Broadband and IPTV. UT current has 500k live subscribers and 2m system capacity. Current booked revenues are $240m, which only $80m has been recognized. These are not impressive numbers considering trials have been going on for years and the amount of R&D and other expenses they have incurred to acquire/develop the technology. However, the key take away is that commercial deployments have started and UT is the leader in very large markets. They have commercial deployments in Brazil (10,000 subscriber deployment now confirmed with Brazil Telecom), China (over 60% market share and 380k live subscribers-compared with 800k for PCCW-leader in HK, also was awarded sole provider for one province), India, and a new Asian country to be announced. UT is also providing the massive NGN/broadband infrastructure that needs to be built to support IPTV and other related products (65% market share in Korea, replacing old Siemens, Alcatel equipment in the Philippines, where other Asian telecoms are reviewing the deployments). The market is aware of this but is focusing on the “timing” when broadband/IPTV revs are going to hit. With the liquidity issue aside, I am more concern now about market share and start of deployments.

-Other technologies/drivers. Gepon, IP surveillance, FMC, new PAS technologies etc will provide future growth as well. Even with all the losses, the company is able to maintain R&D. There is a difference between a dying company burning cash and a company “choosing” to maintain R&D because they see the bookings and potential markets. This really is about the longer term growth and profitability so I agree with the steps taken now.

-China market. Almost every other company tries to get in China and increase revenue there. For the last 3 years, China revs have been declining and they are reducing head count and expenses. Since June, Lu has spent time there and have hired new management, improved controls/customer relationship and looking into the broadband market aside from iptv/pas. Aligning the PAS business back into core was smart to do. They cannot lose the relationship built up over the years. I am happy to see the company is refocused in China.

-Liquidity. This is a concern due to the current cash burn and CB due March 2008. The company was fortunate to have Gemdale and Infinera increased. Barton mentioned they have started monetizing Gemdale last week. They are able to transfer significant sums of money from China and have a target to reduce OPEX to $115-120m. At end of Q4, they still should have over $200m net cash and if they are able to extend the CB, would have half a billion to see this turnaround through.

The timing of the turnaround has always been questionable but this depends on the definition as well. For me, the turnaround has started and will be symbolized by the sale of the PCD division. Blackmore has targeted end of 2008/early 2009 to realize his target ratios. Previous discussions of profitability were not believable because there was no plan. Now, there are cost cuts and bookings to guide management.

The management has laid down a reasonable timeframe and benchmarks. Previously, I had lost hoped and wanted a sale. We are way past that point at this stage and prepared to wait it out. I think the strategy has a very good chance of working and the share price will appreciate significantly.

Monday, November 12, 2007

S&P Lowers 12 month target to $3.5

http://messages.finance.yahoo.com/Stocks_%28A_to_Z%29/Stocks_U/threadview?m=tm&bn=27187&tid=145807&mid=145807&tof=20&frt=2

Thanks to Rspen for posting this early today.

S&P has now cut their 12 month target price from $11 early this year all the way to $3.5 now. I can understand the cut due to disappointment in earnings pushout. But, not due to sum of the parts analysis, specially after their investments have gone up by over $100m. Remember, that sum of the parts analysis at $11 was just early this year! Definitely does not make sense.

Now, lets take a look at their estimates going forward. For 2008, they estimate 2% gains from 2007. That obviously has to go up for a couple of reasons. Q3 and Q4 revs are significantly higher than current estimates. Also, book-to-bill have been 1 to 1.2. They do have a 16% GM estimate but that could change significantly depending on mix and timing. Overall, they have a 87 cent loss for 2008. Thats actually higher than consensus right now but the consensus should go up some. It will be interesting to see how estimates are revised after Q3....

Q3 2007 CC transcript

http://seekingalpha.com/article/53890-utstarcom-q3-2007-earnings-call-transcript?source=yahoo

Sunday, November 11, 2007

Q3/Q4 earnings/revs expectations

http://messages.finance.yahoo.com/Stocks_%28A_to_Z%29/Stocks_U/threadview?m=tm&bn=27187&tid=144725&mid=144725&tof=-1&rt=2&frt=2&off=1

Q3 and Q4 revs are much larger than analyst estimates but GMs are much less in Q3 because of the large PCD mix. On my yahoo post, I was using managements 15% guidance for rev growth in Q3 but it turned out to be 20%. On the surface, this was good but it lowered the revs I was guestimating in Q4. I was expecting the loss to be much lower in Q4 (35 cent analyst predictions) but it seems like its going to be around 26 cents. Still better than expectations but not as big a beat as I was expecting. Q4 could still turn out to be better in revs and GMs so it may come in lower than 26 cents. We'll just have to wait and see what the analysts come up with by next week.

Link to UTs Audiovox buy in June 2004

http://www.tmcnet.com/usubmit/2004/jun/1047983.htm

This was the $165 million buy back in 2004 that now makes up the PCD. This division now makes up more than 60% of revenues but still deliver only 4 to 6% in GMs.

Management has seperated the PCD from the core division and may sell this off in the next year or two. This would definitely help cash flow and focus the company on their core higher margin business.

Gemdale and Infinera holdings

http://messages.finance.yahoo.com/Stocks_(A_to_Z)/Stocks_U/threadview?m=tm&bn=27187&tid=144872&mid=145200&tof=-1&rt=2&frt=2&off=1

Thanks to Tech and Tigre for sorting out UTs exact holdings in Gemdale.

Telephonyonline series of articles on UT

http://telephonyonline.com/iptv/technology/china_iptv_utstarcom_042307/index.html
http://telephonyonline.com/mag/telecom_china_grabs_global/index.html
http://telephonyonline.com/iptv/technology/iptv_lessons_china_051007/index.html
http://telephonyonline.com/iptv/technology/utstarcom_china_iptv_051607/index.html

Ericsson + UT

http://messages.finance.yahoo.com/Stocks_%28A_to_Z%29/Stocks_U/threadview?m=tm&bn=27187&tid=143433&mid=143433&tof=518&frt=2

ML-Report

This was originally posted by on_board_to on Nov. 2, 2006.

To early to be bullish – downgrade to SellUTStarcom’s share price has almost doubled from its lows in June earlier this year. We are downgrading our rcommendation from Neutral to Sell, as we see little evidence that the company’s business model has improved so drastically,and we now believe that the shares are overvalued on both PE and P/B.Operating outlook firming gradually, but in the priceWe have not revised our earnings forecasts, which are ahead of consensus for FY07. While consensus expects the business to remain lossmaking in FY07, we continue to anticipate a gradual improvement in UTStarcom’s operating positionfrom a narrower net loss in FY06 to a nominal profit in FY07 and FY08.Anticipating one key driver, but too many uncertaintiesWe continue to believe that UTStarcom’s outlook hinges on the development of the IPTV industry in China and possibly other parts of the world. However,UTStarcom’s other businesses (PAS and handsets) are likely to exert anincremental drag on the company’s overall operating performance. In addition, it appears that further cost cuts remain central to a successful turnaround.M&A could be a factor, but not necessarily an easy solutionWe concede that management efforts to restructure the operations may result in a sale of some assets that could unlock value for shareholders, but we also believethat this is likely neither a quick nor an easy fix given the divergent profile of the various business units in UTStarcom.PAS - likely to worsen as mobile penetrates rural marketsThe delay in 3G license issuance in China has given UTSI’s PAS handset and infrastructure business a respite in 2006. The PAS franchise has also been aided by improved profitability due to more modest competition and cost savings initiatives at UTStarcom. However, PAS remains in structural decline, and the rising penetration of GSM mobile into the rural market continues to eat into PAS’addressable market.UTStarcom has benefited as the delay in 3G license issuance in China has held back China Netcom and China Telecom from entering the 3G arena, at the likely expense of capex on PAS network upgrades and expansion. Instead, CNC andCT have started deploying UTSI’s Qbox “3 in 1” solution (DSL modem, PAS inhouse base station, and WLAN in 1 box). UTStarcom has also upgraded its PAS radio network infrastructure solution to support WAP packet-mode data (asopposed to circuit based). There is no infrastructure change, but spectrum efficiency should improve. UTSI is also working independently and with the carriers to explore new business models for PAS to sustain the revenue streamas long as possible.
3G remains a looming threat on the horizonFurthermore, the issuance of 3G licenses is more imminent as we approach 2007, and capex for PAS is likely to suffer when the decision is finally made to proceed with 3G – as the fixed line carriers are widely expected to shift theirattention to 3G network development.Handset – insufficiently profitable to matterWe remain most confused by UTStarcom’s handset strategy. Two years after the acquisition of Audiovox, UTStarcom’s handset operations remain a low margin business. It is not big enough to be a major handset vendor, and still operatesmore as a distributor than a true OEM given limited internal development capabilities. As such, the handset business suffers from low profitability with midsingle digit gross profit margins. The company is relying on niche solutions like the comparatively new T66 dual mode GSM/CDMA handset to win share, but we see these as relatively finite opportunities that are unlikely to make the company a serious player in the handset market. As such, we believe that there is limited revenue and margin upside for this business given the following factors:ô€‚„ The increasingly competitive overall landscape for mobile handsets,ô€‚„ The challenge of increasing value added without increasing development costs, and ô€‚„ Inability to attain critical economies of scale and scope needed tobreakthrough into the next level of the market.Management believes that it can improve GP margins, and that this is the key to improved profitability given that expenses are mostly fixed. While we agree that there is some upside potential to gross margins, given the low base of the current distribution oriented model, but we are also cautious of inflating expectations forthis business given the intensely competitive nature of the handset market.Wireless broadband - looking for an exit?After a series of M&A deals in 2004 and 2005, UTStarcom has been consolidating its wireless broadband initiatives. It is now primarily focused on radio network controllers (RNC) for TD-SCDMA technology in China. The company has exited the WCDMA infrastructure business, but continues tomaintain customer support for TD-CDMA projects that were deployed by PCCW in the UK. The company remains active in developing wireless access solutions using CDMA EV-DO, Wimax and PAS technologies.
Broadband - urgent expansion needed to offset PAS declineIn our view, the emerging broadband wireline business offers the best chance ofoffsetting the pressure from the shrinking PAS franchise. However, business visibility remains limited due to regulatory and technological factors. In addition, analogous to the rapid commoditization of the DSLAM market, we fear thatUTStarcom ultimate profitability for new broadband businesses may ultimately be subject to similar margin pressures, due to the consumer orientation of the services to be supported.IPTV – looks promising, but can it deliver?UTStarcom is already in a position to support the total value chain for IPTV in China and in other markets around the world. In China, the company’s partnership with the Shanghai Media Group has given UTSI a leading position inthis emerging market segment. It is anticipated that the government will soon issue more licenses. One of the strengths of UTSI’s IPTV solution in China, is itscontent mgmt platform (CMP) that has been a key requirement for the State Administration for Radio, Film and Television (SARFT) to embrace broader IPTV deployment and commercialization. Nevertheless, management continues to offer conservative guidance on commercial prospects for IPTV in China - noting that although constant development is underway, it will take some time to realize its full potential.10-40% boost to gross profits possible if IPTV takes offUsing simple, conservative assumptions, we estimate that IPTV in China could boost UTSI’s current gross profit base by at least 10% conservatively and up to 20-40% per annum going forward. This does not take into account reducedcontributions from PAS handsets and infrastructure which currently contribute ~40% of UTSI’s gross profits.Assuming 10% penetration of the approximately 80+mn urban households in China in the next 5 years, with UTSI capturing a maximum market share of 50% only gives 4mn subs on UTSI equipment. At an estimated revenue of $200 persub (including backend CPE and subscriber STB), the revenue opportunity translates into up to $160mn in annual sales for UTSI. We estimate gross margins would range from 40% for CPE to <20%>90% TV householdpenetration in China and more significantly, projections for almost 50mn broadband internet subscribers in China at the end of 2006 and about 60mn at the end of 2007. However, these numbers do not take into account that some of the connections may not have the necessary infrastructure to carry higher bandwidth IPTV signals, or likely competition from digital TV rollout by cable operators.In the mid to longer term, we believe that the potential Chinese IPTV market is could be between 30-60mn households. Even if UTSI’s market share was only 30% and blended gross margins were only ~25%, the potential margin contribution to UTSI could still be up to 2 – 4x higher than our conservative baseline scenario above. The question we cannot answer at this time is how quickly this potential can be realized.Geographic outlook - mixed Beyond China, which remains a critical market for both PAS and IPTV, UTStarcom is trying to build on its momentum in India, defend its position inJapan and build on its wireless handset franchise with North American mobile operators, and other markets in theUTStarcom appears well positioned in the IPTV value chain in China Management continues to offer conservative guidance on IPTVBase case scenario has IPTV accounting for >10% growth in gross profits, assuming other businesses do not declineIPTV likely to face competition from digital TV and possibly inadequate broadband infrastructure
IndiaUTSI remains bullish on its prospects in India, where it believes that it is the leading broadband wireline infrastructure provider – serving all tier 1 customers inthat market. UTSI is currently participating in IPTV trials in India, and is hopeful that it will be able to leverage its early success in China into a similar position inChina. We believe that it is too soon to tell.Japan While UTStarcom had previously benefited from rapid deployment of broadband services by Yahoo BB/Japan Telecom, this business has slowed as Softbank has shifted to focus on wireless with its acquisition of Vodaphone Japan. We do not anticipate a quick bounce back there unless Softbank reorients its strategy.Earnings outlook – no margin for error The near term earnings outlook is for losses to continue through the end of 2006.However, the company expects to breakeven in 1H07, and our model suggests that this can be achieved if costs are cut further and there is no revenue slippage. However, we caution that based on current assumptions, the margin for error is slim, and failure to deliver adequate revenues or cut costs will result in further losses in FY07 and even FY08.ô€‚„ To this effect, management is focused on the following initiatives:ô€‚„ Further internal reorganization,ô€‚„ Refocusing resources on key product lines that matter,ô€‚„ Improving scalability of new product development efforts, andô€‚„ Focusing on key customer accounts.3Q06 guidance – losses to continue Management presented 3Q06 guidance for revenues of ~$590–625mn, with blended gross margins of 16.5–18.5%. The company projected operatingexpenses of ~$135–140mn (including ~$4mn in stockcompensation). EPS for the coming quarter was projected to a loss in the range of $0.23 – 0.33. Taxes are expected to be around $3mn in the quarter.In 3Q06, the following gross margins are expected for UTSI’s different product groups: Handset are projected at >5%, PAS is expected to be 23-25%, wireless infrastructure is expected to be 45-47%, and broadband is expected to bebetween 17-19%.
FY06 guidance – losses likely to extend into 4Q06For the full year, UTSI management expects to report a net loss, but to generate positive cashflow. The company is targeting to return to profitability in 1H07. Fundamental problem - more operating cost savings needed A key factor that is holding back UTStarcom’s sustainable profitability is its operating cost base. While the restructuring has reined in annual operating costs by ~$100mn from a peak of $650mn in FY05 (excluding US$250mn in restructuring charges) to a projected $545mn in FY06, this level may still be too high for UTSI’s base of gross profits.India could be a surprise, but business terms are likely tougher than in China Unless revenues pick up strongly, the key to profitability is through further cost cutsHigh fixed cost based poses continue risk to earningsWe have already assumed in our model that UTStarcom management will cut costs further in FY07 and FY08. However, even with this reduced operating expense assumptions, we are only projecting UTSI to achieve marginal levels of profitability in FY07 and FY08, unless PAS revenues are far more resilient than we have expected or IPTV revenues kick in more strongly over the course of the next year or so. If UTStarcom fails to meet our revenue projections or secure the additional cost savings, there is a real risk that the company may not meet our breakeven earnings projections in FY07 and FY08. Restructuring or asset sale to unlock value Earlier, management announced that UTStarcom’s board of directors had established a special committee to “examine a range of short and long-termalternatives” with the aim of optimizing the value of the company and its opportunities with respect to the share price. We concede that management efforts to restructure the operations may result in a sale of some assets that could unlock value for shareholders, but we also believe that this is likely neither a quick nor an easy fix given the divergent profile of the various business units in UTStarcom. Selling attractive assets like the IPTVbusiness would be feasible, but would leave behind an unattractive mix of assets.Disposing of unattractive assets like the handset business or the PAS franchise isunlikely to generate a good price given the more modest operating prospects of these operations.Recommendation – SellWe are downgrading our recommendation on UTStarcom from Neutral to Sell.We believe that the company has a reasonable chance of meeting its target to return to profitability in 1H07, but it is premature to assume that it can achieve asufficiently robust normalized level of profitability to support the current share price.The current share price assumes that either mature businesses like PAS and handsets will deliver sound results while emerging revenue streams like IPTV take off faster than we have projected, or key businesses will be acquired at favorable terms. We have little hard evidence at this time to assume that the bestcase scenario will pan out. Until there is greater visibility on the company’s operating outlook, we believe that there is downside risk to levels that reflect amore modest premium to UTStarcom’s projected book value of ~$7 per share.What would make us more positive?We would reconsider our negative opinion on the stock if UTStarcom is able to:ô€‚„ Dispose of key assets at favorable terms, orô€‚„ Deliver a sustainably stronger than expected operating performance with enhanced operating visibility.