Saturday, June 13, 2009

A Viable Business Model

The announcement this week by the company to cut yearly operating expenses to less than $100m was stunning and radically different from previous behind the curve/half baked restructuring actions. Lets look at the outlook/ramifications of the cuts going forward.

Divided BOD? - On Friday, various institutional investors had the opportunity to talk with Peter Blackmore/Viraj Patel and came away feeling that there could be major divisions among the board between the strategic steps the company have and would take. Peter Blackmore came in 20+ months ago with an operations background and very early on focused on streamlining the company. After about 9 weeks, they came up with a plan to divest non-core assets as well as improving sales, marketing, and operating management of the company. While those were significant moves by itself, the model was also predicated on a revenue ramp (despite ongoing PAS declines) to achieve Peter's targetted expense metrics goal of around 25% for both SG&A & R&D. Peter discussed the company as a "startup" and asked people to measure their progress by the bookings. The company executed on the divestitures part but not on the revenue ramp and the rapid deterioration of PAS sales and the very slow ramp (in some cases) of iptv and other core products forced the company to slash costs by $100m late in 2008. The global meltdown late in 2008 did not help but the primary reasons were company specific (such as PAS closedown, regulatory issues, etc). This is evident by the continued growth by companies such as Huawei and ZTE.

Anyway, I digress. Despite the public statements by the company of good core bookings, I believe Peter knew that the restructuring/divestitures were not enough, the core revenue ramp was not enough, and that the company needed to do something more drastic. This is a credibility issue that Blackmore has but it doesn't mean he doesn't know what needed to be done. As an investor, I also rely on projections based on the company's public statements. This definitely hurt a lot of investors as the stock went from $5-6 to under $1. A major turning point or peak of my frustration was the time of the Q4 2008 earnings call. The company projected $125m in Q1 revenues which was way below expectations and then left investor's with the company trying to cut quarter opex to under/around $60m/quarter by the end of 2009. What??? Even for this company, this was ridiculous. The stock plummeted from $1.1 to under $1 despite the company having cash/book value that was 4 to 5 times the market cap. The street basically said it looks like the company will continue their business as usual ways well into 2010. Obviously, this is NOT acceptable for shareholders and we organized as best as we can. I increased my postings to highlight the fact that the stock was pricing in this scenario and shareholders needed to be as vocal as possible because there is tremendous value wasted (as if the previous years were not bad enough).

The stock dropping to $1 I believe also made it ridiculous enough that the people in the company that favored more cuts finally had a platform. It took months and there were rumors of more cash injection, selling out the company, and more job cuts. It all culminated yesterday in the massive restructuring. I initially listed the benefits of a handset investor but then wondered what price could they have paid if the deal was negotiated when the stock was under $1 or in the low $1s? This would be inconsitent with the company not diluting the existing share base as they did not last year when paying the CB.

Anyway, I believe the rumors of an investor was still valid and obviously, there are always major resistance to any cuts, let alone this magnitude. Again, I probably gave the history of the world but it is important to go through to understand the weaknesses of the company and where do we go from here. I believe Peter is fully in control and sets the tone of the company. There is resistance in the board but obviously supporters as well. I believe Peter got the cuts he wanted and now is comfortable with the metrics and revenue expectations going forward. I don't believe that management/board gets a pass for their credibility issues and believe that Lu should not be re-elected. I also believe that if Lu gets voted down and submits his resignation that the board will accept.

For people that have been waiting for this announcement before voting, there is no real other option now but to vote against the re-election of Lu. I also voted against Jeff Clarke because he is part of the board but will not campaign on that. I voted against the accounting firm because for the last 2 years, they have been paid $11.5m and think that is just outrageous for a company the size of UT.

Dream being dead? - Some people will say this is a sad day for UT? Why? The dream of UT being the Cisco of China was long over and Huawei/ZTE were the ones who benefitted from the China boom. UT was not going to "compete" with Huawei whether it had $180m/quarter in opex or $25m/quarter. Most investors "dreams" are to get to profitability as quickly as possible and potentially sell itself. Even this dream for me was gone because the company, even with Blackmore's yapping about revenue growth/cost cuts, just didn't seem to "get it" and continued with its yearly end of the year cuts and projections for better days with a lot of very hopeful assumptions. Thats why I changed course and just hoped for the company to sell itself. The announcement yesterday was very significant. Does this bring the hope back that it will be the next Cisco or Huawei (ironic)? No. It does bring the realistic probability the company will be profitable in the near term and then can have better options to sell itself or organically grow its profits/earnings from there.

Cash Flow- Blackmore emphasizes the cash because they will need it to get to the profitable business model. The company has $301m in cash at the end of Q1. They will go through another 3 quarters of losses at the minimum. They will incur restructuring charges of $40-45m. On the positive cash flow ledger, the company will take in $100m as part of the Phase I & II India contract throughout this year. This is not part of the "revenue" estimates due to the accounting rules. As I was informed, Phase I will be completely paid of by Q2 and even some of the Phase II contract will not be paid until 2010. There are the Korean designed handset inventories to still wind down. There is also $10m left over from PCD escrow to be paid in July. Will the company burn through all the $300m in cash this year? No. Lets do a little math. Lets assume that core revenues for the rest of the year at $90, 100, and 110m for a total of $300m. Thats $75m in gross profits. Lets say opex is $65, 60, and 55m for $180m in opex. Thats an operating loss of $105m. So, lets add it up.

$301m - $105m + $20m (Handset inventory wind-down) - $45m (restructuring) + $10m (PCD) + $75m (India Phase I/II for last 3 quarters) -$15m (other expenses, taxes/options) + 0 for interest earnings/currency fluctuation/etc) = $241m. Lets "round this off" to $200m just for any other contingencies. Does this seem like the cash is going to zero?

The company is in dicussion with the Phase III BSNL contract but that is towards the later part of the year. Even if they have to spend ahead for inventory, it will be $60m or so. The larger it is, the better for UT since it means the contract is higher.

Breakeven point for 2010 - Blackmore laid out the business model needing $350m in revenues as the breakeven point. Thats an assumption of about 27 to 28% GMs with an under $100m opex. The GM assumption is debatable but it will not include significant handsets (and they are only targetting "strategic handsets" for their mobile iptv, etc). An analyst even commented how come the GMs is way below the industry standard (around 35 to 40+%). Blackmore mentioned the set top boxes had low GMs but that could be outsourced as well. Anyway, the driver now will be core revenue and those can be tracked by bookings. Another point I want to make. FINALLY, we are not talking about revenues without PCD, without internal PCD, without PAS infra, without PAS handsets, without Korean design handsets, without China handsets.. There may be very little handsets but basically 2010 revenues will finally be core products. Geeez...And any revenues book now will be products that are not "legacy" types. These will be hard earned revenues in this environment.

2009 Bookings - Q1 revenues was $119m but about $40m in Korean-handset design inventory being closed off. That leaves about $80m. There may be some other non-core sales there but one institutional investor clarified the 1.2 (book to bill ratio) bookings for the core and was it $96m and the company said that is a good number. (Who knows if this is true but that is the best we have for now). Q2 bookings will be announced when Q2 cc rolls around but Blackmore indicated that China bookings are on track and international bookings are ahead of projections. An Analyst asked during the call if the international bookings are primarily in India but Blackmore mentioned its in other places as well such as Korea, Taiwan, and the Philippines. Blackmore mentioning Taiwan is very interesting as the iptv contract for Taiwan was press released in December of 2007. Blackmore also mentioned that iptv just went live in Taiwan a month or so ago (I gave a sarcastic comment in my blog posting at the time but that may be going well enough that they are booking material revenues now). During the initiatives call, Blackmore talked about iptv/softswitch as being more mature technologies and GEPON/TN as products they will require more investments. It is a very positive sign that bookings for Q1 is around the $90-100m range without GEPON/TN products having any or very little impact. That Q1 number also didn't include potentially the Phase III BSNL contract and shouldn't the 2nd half of the year bookings be better than Q1?

Working Capital - The company has no debt, has short term credit lines in the $100m+ range, and cash. Looking at 2010, the business model could be a $350m revenue company, under $100m in OPEX, $200m in cash, and the credit lines supported with a $170m building that they own. Is that not a sustainable business model?

Tangible Book Value - I think Tigre, another shareholder, brought this metric a while ago and it was deteriorating. I argued that who buys the company based on the tangible book value. I was wrong to ignore this metric and have used it often to gauge the stock price as it has fallen way below the book value. As a company losing money, using cash/book value is useful but as I originally mentioned, its less correlated for those that are profitable. A tech company trading below tangible value is a major sign that it has problems (as if the stock price declines was not warning enough). Anyway, I expect the stock to trade above the book value as it loses cash to get closer to breakeven/profitability. Eventually, it should trade much higher than book value as the focus becomes earnings power/growth of the business.

Startup/Chinese company/Credibility - There are obvious risks and the issue with UT board and not being "Chinese". Institutional investors have been discussing this with management on an ongoing basis for a long time but just like the Starent lawsuit, takes time to play out. This in no way ignores this very important issue. There is also the credibility of not getting ahead of the curve for so long. Peter has talked about the company being a startup and at the same time mentioned that UT is unlike other companies because of their background. While it is not a pure Chinese company, at this stage, we can look at things from a half glass full point of view. Unlike a Starent for ex trying to break into the PSDN market in China, UT being a semi-Chinese company with years of operations has advantages. UT, having worked on their technologies for a decade, does have advantages in having a wider product line using less resources than someone just starting out. The company having no debt is a tremendous advantage and owning their building has tremendous advantage. While a few years ago, we may have given too much credit for these intangible assets, the extreme case of looking at the glass half empty or empty is now wrong.

Share Price - Do I have a crystal ball? Well, yes, but it doesn't work sometimes. Technically, there was resistance in the $2.5-2.6 levels. Short term, you always have to look at technicals as it incorporates money flow and other factors that we don't forsee. I do think that the stock will generally trend higher as 2010 (only 6 months from now) approaches. While a sale would have been great from a short term pay off, this restructuring is significant and will pay shareholders in the longer term. The institutions probably know all of the above metrics, etc but my main audience has been those retail shareholders just like myself that have been "stuck" with a higher cost basis. There are always opportunities (specially in this market) elsewhere but I believe the opportunities (risk/reward) in UT at these levels are as good if not better than other investments. That of course is up for debate but this is a UT blog so I focus on the UT investment. I don't get in diversification or commodity speculation or shorting or whatever. There are plenty of other sites and analysts for that.

Have a good weekend.