Sunday, November 11, 2007


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:􀂄 The increasingly competitive overall landscape for mobile handsets,􀂄 The challenge of increasing value added without increasing development costs, and 􀂄 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.􀂄 To this effect, management is focused on the following initiatives:􀂄 Further internal reorganization,􀂄 Refocusing resources on key product lines that matter,􀂄 Improving scalability of new product development efforts, and􀂄 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:􀂄 Dispose of key assets at favorable terms, or􀂄 Deliver a sustainably stronger than expected operating performance with enhanced operating visibility.

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