Monday, December 28, 2009

Building Sale

After selling their property, UTStarcom will lease back part of the facility.

"The Company will lease back 70,000 sqm gross floor area ("GFA") aboveground and 12,000 sqm GFA belowground of the property for a period of 6 years at a rate of RMB 2.5, 3.0 and 3.2 (approximately US $0.37, $0.44, $0.47, respectively) per sqm per day for years 1-2, 3-4 and 5-6, respectively, of the leaseback period for the aboveground space; and for RMB 25 (approximately US $3.66) per sqm per month for the underground space for the full leaseback period.

The Company may terminate the Agreement for any reason prior to the transfer of the title to the property upon repayment of all amounts paid to the Company by the Buyer and payment by the Company to the Buyer of an additional RMB 50 million (approximately US $7.3 million)."

One poster wrote that this is a very bad deal for UTStarcom.

My response is in italics.....

Tim, I admire you willingness to look for positives in this situation, but I totally disagree about your assessment of the deal. I believe it is very bad. Here are my reasons:

Johnny, Nothing to admire really. Your points are very easy to disagree with and management is just going by a very rational playbook (not going to give them genius status either).

First, the property was sold below book value. I did not expect them to get $760M – after all the local government was not likely to allow a US company to profit from speculation in Chinese land. However, given the property value, I expected they will get the full book value. It turns out that we have to take an impairment charge.

1. Book Value? You can talk all about what something is worth but if you cannot sell it or make use of it effectively, then its not worth what it says on some book. A lot of bashers looked at the property as zero since they could not monetize it. Now you and others think this is much more. As I've mentioned, anyone can step up and pay $7.3m and take over the deal if it was such a great deal. I say its a fair deal for both sides (win/win as both got what they needed out of the deal).

Second, the leaseback price is much higher than it should be. I expected it to be about $3M/year. A typical amount of yearly rent in undistorted markets is about 1/15th of the purchase price. In case of this transaction, that would be $9.3M for the entire building. Since UT leases only about a third of the building, I consider $3.1M to be reasonable. Selling the property some 80% below market value, the seller should be able to negotiate reasonable (as defined above) leaseback terms, because he has the option of walking away from the deal and denying the buyer the arbitrage profit (unless it is a sale of desperation as please_buy_while_I_sell suggested). The buyer still has 2/3 of the building to be leased out at the market rate and gets to profit from arbitrage when he eventually sells the property. Very generous terms for the buyer, with much lower leaseback payments.

2. Do you really think anybody would spend $140m and only expect to get back $3m/year in lease. We're not talking about liquid US treasuries here either (and those yield higher than 3/140). Again, the only reason UT was even able to monetize it is because they were willing to lease it back and give the buyers cash flow for a certain number of years.

Third, and most important, it adds $11.4M to yearly expenses (average over 6 years). At gross margin in upper 20s, UT will need approximately $40M in extra sales just to pay the rent. I just don’t see them bringing in those sales.

3. For UT, spending $11m/year is not too much considering how much they were spending in the US in rents (that they have cancelled already and shifted operations to China). The amount is probably less if they tried to borrow the money outright. How many people would lend at close to "book value" anyway and there is no comparable building for sale/lease there. UT gets $131m in cash during a very difficult credit environment. Most endowments or funds can make 7-10% with no problem.

Feel free to disagree.

Can the property go up? Sure. Can UT borrow against it? Sure. Can UT lease the other parts of the building? Sure. However, none of those are a certainty. Cash is a certainty. Flexibility/liquidity is a certainty. With the additional cash/working capital, they have also increased the ceiling for amount of contracts they can go after. Without the sale, they had a much lower ability to win additional contracts simply because of their working capital. UT is reducing their overall risk profile (lowering expense structure, selecting better contracts, building up cash) in very uncertain times. The liquidity/monetization is really a no brainer excellent move for UT at this stage.

Ultimately, UT core business has to show growth and profits. This sale (as part of a series of moves over the last couple of years) puts the focus on the business/operation side where they will have simplified/resolved the following metrics:

1. $350m revenue (high 20s GMs) breakeven point.
2. Less than $100m in OPEX.
3. More than $300m in cash.
4. Operations back in China.
5. Targetted markets/clients in China, Japan, and India.

They have really put themselves in a highly flexible/liquid position as compared to just a year ago when they were dependent on PAS/PCD.

Have a good rest of the holidays everyone!