By Ari Bensinger
I wish I had a dime for every time I've heard the term "poor visibility" in a communications-equipment outfit's conference call. I would quickly accumulate an amount equal to the current market cap of some of those very same depressed companies!
Nevertheless, poor visibility isn't just a buzz phrase that's used as an excuse when corporations miss their lowered sales guidance. It's the truth. To spur cash flow and boost their stock prices, telecom carriers continue to lower their capital-spending budgets to the lowest levels in decades.
It's no wonder that equipment suppliers continue to struggle for profitability and miss their earnings targets. But one is seeing higher sales and is exceeding its forecasts: UTStarcom (UTSI ) in Alameda, Calif. It has consistently surpassed the Street's estimates and raised its earnings-per-share guidance in most of the 10 quarters that it has been public.
One reason for UTSI's enviable record is its conservative revenue-recognition policy. UTSI records revenue only when it obtains customer acceptance of products, instead of booking it as soon as the products are shipped. Goods sent to customer locations but that haven't yet received final acceptance (meaning the customer is happy with the product) remain in inventory on UTSI's balance sheet. This practice helps predict revenue.
While other communication-equipment companies refuse to give specific revenue guidance, UTSI says 100% of its third-quarter revenue is from previous orders, and 50% to 70% of fourth-quarter sales are already booked.
UTSI provides equipment for wireline and wireless telecom networks. For traditional wireline networks, it offers a broadband-ready access system called AN-2000 that consists of both central-office terminals and remote terminals linked together to form a digital access network. UTSI's mSwitch delivers multiple voice and data services using a highly distributed architecture. The company also markets a variety of handsets manufactured by multiple Japanese manufacturers under the UTStarcom label.
The bulk of its revenue, however, is derived from its "personal access network system" (PAS), which allows service providers to offer voice and data services over fixed wireless and citywide wireless mobile networks. Its mobility functions are completely integrated into the access network architecture and require no central-office switch modification or incremental mobile switching hardware. By integrating PAS into the existing access network, service providers can take advantage of unused central-office switching capacity to carry incremental wireless traffic loads.
PAS enables telecom providers to create networks in emerging markets having not only have the reliability and scalability of wireline services but that also provide consumers with the convenience and mobility of wireless service. PAS has a strong history of success, with approximately 8.1 million lines installed in 268 cities around the world.
UTSI's most significant success has been in China, which has more than 9 million PAS subscribers. Given its entry into the World Trade Organization and considering that the Olympics will be held in Beijing in 2008, China is more determined than ever to ensure that it's telecom infrastructure allows it to compete in the global marketplace.
The country's demand for communication services is highlighted by its low "teledensity" rate -- a measure of the number of lines per hundred people -- of about 14%. That compares to a teledensity rate of 40% in Europe and 66% in the U.S.
China's ability to invest heavily in its communication infrastructure is fueled by its strong economy. The Economist Intelligence Unit -- a leading provider of economic, political, and business information -- estimates that China's gross domestic product will grow at a compound annual rate of nearly 7.5% from 2001 to 2005.
Driven by robust growth, pent-up consumer demand, and Beijing's commitment to an advanced infrastructure, Standard & Poor's expects China's communications market to exhibit extremely strong growth over the next several years. Over the past 10 years, UTStarcom has built an expansive network of access lines and established relationships at all levels of China's telecom industry, making it well-positioned to benefit from the country's robust telecom growth.
In late August, UTSI's stock price came under considerable pressure, as the company's largest shareholder, Softbank, sold 12 million common shares over two days (6 million shares in a block trade, and 6 million shares to UTSI as a buyback). The sale reduced Softbank's stake in UTSI from 32% to 20%.
We believe that Softbank's selling reflected the need to generate cash to help support startup costs of its broadband service, Yahoo BB, in Japan rather than any negative sentiment toward UTSI's outlook. We also note that Softbank needs to retain its current 20% ownership to report UTSI's profits in its earnings. Indeed, Softbank reiterated its commitment to UTSI by voluntarily signing an agreement not to sell any more shares until March, 2003.
A bigger challenge for UTSI concerns PAS's technological limitation. Since PAS is overlaid on a fixed-line network, its wireless ability is confined to the home network, so PAS phones can't "roam," or be used outside a local area. Most observers view PAS as a transitional technology until cellular systems become more readily available in China. In particular, investors are wary that UTSI's primary customer, China Telecom, will likely receive a license to offer cellular service sometime in the next few years.
China Telecom will plenty of time to launch such a service and convince its customers to pay more for it. PAS service is much cheaper than cellular technology: On average, customers pay about one-eighth the cost of cellular service available from the major Chinese operators. That's why customers usually own two phones, a PAS handset for home use and a cellular device for outside their local service area. Plus, PAS is attractive to carriers' bottom lines, since the return on investment for it is about two to three years, considerably faster than cellular.
Given the strong demand for UTSI's wireless and wireline access products, we expect 2002 revenue to rise 50%. Gross margins should widen about 100 basis points, to 37%, as UTSI sells more products outside China (margins are higher in other nations) and as handset margins rise. We project operating margins at an impressive 16%.
Overall, we at S&P forecast earnings per share of $1.01 in 2002 and $1.36 in 2003. We believe our earnings estimates could be revised significantly higher as UTStarcom increases its exposure outside China to developing nations such as India and Vietnam.
Given our assumption that China's telecom market will continue to show strong growth, we believe UTSI will increase annual EPS over the next three years by 30%. With shares trading at a price-to-earnings multiple of approximately 15 times our 2002 EPS estimate, and a related p-e to growth (PEG) ratio of 0.5, well under the peer-group average of about 1.0, the stock appears undervalued.
The balance sheet is solid, with a low debt-to-equity ratio and a strong current ratio of 3. In light of UTSI's attractive end-market opportunity, upside earnings potential, and relatively low valuation, we have an accumulate recommendation and believe the shares are likely to outperform the S&P 500-stock index over the next 6 to 12 months.
Analyst Bensinger follows communications-equipment stocks for Standard & Poor's
Edited by Karyn McCormack