Sunday, February 24, 2008

Expenses and mandate of the exploratory group

The last profitable quarter was in early 2005 but that was due to recognizing the huge $290m Japan Telecom contract. The last profitable year was way back in 2004. It will be late 2008 or even early 2009 before the company can even get back to profitability and may take up to 2010 for full year profitability according to some analysts and projections.

One of the main obstacles getting to profitability is expense control during the last few years. While there is no question the PAS downturn and lag in other products have contributed significantly to losses, expenses have not come close into being in line with the revenue losses. During the last earnings call, Peter Blackmore put up some target expense ratios to return the company to profitability. He based this on the core revenues, which investors have been hoping the company would do for a while.

From the earnings transcripts which I encourage people to read before the next call,

"The model for our R&D is between 10-11% of our revenue, excluding PCD. We believe this is a reasonable ratio for an infrastructure business. The SG&A model is between 13-14%, excluding PCD. Excluding PCD revenues is the right way of looking at our cost base, as PCD is a stand alone business."

Peter adds: "They will all get to benchmark by end of 2008."

If that was the case, and the company returns to profitability by end of 2008/start of 2009, the share price today should be at the minimum $5/share or a $600m market cap (an amount close to shareholder equity at the end of 2008). But, the stock is still under $3 and target prices for the next 6-12 months are $3-3.5. Why? The street simply does not believe the company can get to these benchmarks.

Lets look at the previous years expenses/revenues and an estimated expense/revenue based on CSFB report.

The last time that the company had expense ratios that are what Peter is targetting is back in 2004, the last profitable year (and a very profitable year to boot). Ever since then, the ratios have ballooned to 42% and 23% for SG&A and R&D respectively at the end of 2007. Even if I factored in revenue from 30% of the PCD, the ratios stand at 26 & 14%. Now, this does not include the cost cut benefits and other expenses that will not be incurred in 2008. With the higher revenue projections/lower costs, the expense ratios will still be 22 and 12% for 2008, far higher than the 13.5 and 11.5% target expense ratios. Of course, Peter could be targetting the traditionally higher Q4 2008 to reach his metrics but obviously, this needs to be sustainable as well.

Lets go back to the PCD. If they are truly an infrastructure company, and I still include PAS handsets but completely exclude PCD revs, then core revenue based on SG&A (at 13.5%) would be over $2b, which is almost 3x projected revs in 2008. Core revenues based on R&D (at 11.5%) would be $1.36b., which is more reasonably attained. What this shows is that SG&A is simply too much. I don't have as much of a problem with R&D expenses as I believe the core revs from broadband and iptv will significantly ramp in 2009 (book to bill in 2008 should confirm this). Anyway, management has to signficantly continue to slash SG&A in 2008. It should not be a moderate cut but a signficant cut.

Some additional comments and conclusions.

1. Management should break down book to bill for PCD and non-PCD going forward.
2. The PCD is a huge asset right now but the company needs to reduce expenses and not play around with the ratios as part of the PCD. Barton mentioned that there is minimal R&D/SG&A related to the PCD in the terminals business unit. This highlights that SG&A is WAY too much.
3. Most of the core revenue growth will come from iptv/India broadband for now.
4. What has the R&D over the last few years yielded? Most of the core revenue still comes from PAS, and some iptv/wireless, which were mostly paid for 5 years ago. Lu mentioned he is working on "broadband access products, GEPON and Optical transport" in China. There has been mention of wimax, ip surveilance, base stations in the US, submarine/emergency applications, fixed mobile convergence, etc. However, has someone done an evaluation of the revenues/profits these new technologies are bringing in compared to the $1b they have probably spent in the last 5 years?

These are fundamental questions that need to be answered by management and the BOD.
Even if there is an explosion in iptv in 2008 and beyond, there has to be an accounting on research and SG&A going forward. The PCD has performed very well but it should not be counted on for running an infrastructure business. Without the PCD in 2008, the company would lose $200m. There is no liquidity problems even with the upcoming CB because of their signficant inventory (over $600m) and cash/short term securities ($600m). The question in the future is whether the next surge (in iptv) will make the company just breakeven/slightly profitable or VERY profitable, which is what I hope this company has been spending for the last 5 years.

For some people, this continues to be a long term proposition which they expect to be a huge winner. However, there has to be a thorough evaluation of shareholder value here at this stage, which the group is trying to address with management.

If the company cannot control and slash their expenses and get to very profitable status, and if management feels they have to spend so much to compete and maintain their technology, then it may be time to plan for strategic alternatives during the next upturn and not wait until the next downturn.

I have listened to both longtime shareholders and their wish to give the company time and I have listed to the shareholders who want immediate change. I hope both sides can see that it is not an easy black/white situation here but one thing is for sure, the current shareprice and performance is not acceptable. Management has been saying this for years as well but have been unable/unwilling to get the job done. This is where shareholders and this group has come in and thats why it will need to be a sustainable effort on our part as well.

No comments: