UTSI: Shrinking Revenue and Pending Damages on Bribery Charges -- Can You Say 'Short'?

| About: UTStarcom, Inc. (UTSI)

David Riedel of Riedel Research Group recently published this note for clients as to why they should no longer hold onto shares of UTStarcom, Inc. (NASDAQ:UTSI). Excerpts follow:

UTSI announced a loss of $10.6 mn in 1Q2006, about 23.5% of loss in 4Q2005. The narrower loss is caused by shrunk revenue and costless cancellation fee of $22 mn from Japan contracts. We believe in the next quarter revenue will maintain its downward trend, while loss will swell. Before we see IPTV revenue, no business segment can be appreciated. UTSI disclosed two bribery scandals in Mongolia and India, which may negatively impact UTSI, if UTSI is sentenced guilty. We calculated a target price of $6.30, which is below the Company’s current market price and net asset. Bottom line: SELL.

Narrower Loss, Less Revenue

Click all charts to enlarge UTSI 1

UTSI announced a loss of $10.6 mn in 1Q2006, about 23.5% of the loss in 4Q2005. (Exhibit 1) Following aspects caused the loss decrease. Total revenue in 1Q2006 dropped by 11.7% QOQ. (Exhibit 2) Even if profit margin did not change, loss would decline with revenue drop anyway. Further, cancellation fee of $22 mn from Japan contracts costs UTSI little and raises gross profit margin.

We believe in the next quarter, revenue will maintain its downward trend, and the loss will swell. (Exhibit 1, 2) We believe that the company took every advantage available in the first quarter to minimize the loss which indicates that there will be fewer opportunities to mitigate the loss in 2Q, UTSI’s CFO suggested revenue recognition of IPTV deployment may have lagged 6-9 months since contacts were signed. The PAS {1} market is stagnant, while IPTV {2} revenue will not be recognized recently, therefore UTSI has to experience a depressed year.

UTSI 2

Almost No Segment Will Show Growth in Next Quarters

Without Japan contracts, revenue of broadband infrastructure in 1Q2006 decreased by 39.1% to $57.2 mn, actually $22 mn of which is costless cancellation fees from Japan contracts. After selling Softbank stakes, Softbank has no obligation to consider UTSI’s interests. Therefore the profit margin of broadband in 2Q will be much lower than in 1Q. (Exhibit 3) Handset profit margin should drop in the future as average selling prices [ASP] for the industry are dropping. UTSI expected PCD {3} profit margin will continue to recover, but revenue of the segment will decrease. UTSI also expected the wireless and wireline business revenue in 2Q will maintain the same level as in 1Q, but profit margin will also drop.

UTSI 3

Bribery Scandals in India and Mongolia

UTSI disclosed two bribery scandals. In December 2005 the U.S. Embassy in Mongolia informed Department of Justice that an agent of UTSI’s Mongolia joint venture offered improper payments to a Mongolian government official, which is possibly violate the Foreign Corrupt Practices Act. UTSI also announced they became aware in April 2006 that an UTSI agent may bribe an Indian government official. That should be the reason that UTSI delayed its reporting again and again.

The Securities and Exchange Commission [SEC] and Department of Justice are investigating that whether bribery allegations are true and whether the behaviors of those agencies are related to UTSI. If UTSI is judged guilty, there will be much negative impact on UTSI’s financial situation and, therefore, the share price.

Someone in a telecom equipment provider told Shanghai Securities News that briberies are not uncommon when a telecom company wants to enter an emerging market like Latin America or Asia. Though it could be understood that UTSI tries their best to survive the hard times, investors must not hope UTSI risk anything illegal.

Valuation

We believe the Japan market impact on broadband will end in 3Q and the broadband revenue will grow slightly from then on. But we believe PCD division will maintain a significant drop in the future. We assume wireless revenue will maintain a QOQ growth rate of 0.5% in year 2006 and 2007, while handsets revenue will maintain a QOQ growth rate of 8% in the same period.

We also assume the growth rate of service business revenue will be more than 30% in 2Q2006 and will drop to 20% thereafter. UTSI expected IPTV revenue will be recognized 6 – 9 months later, while we believe revenue will stop its downward trend at the end of next year. We calculated a target price of $6.30, which is below UTSI’s market price and net asset. Bottom line: SELL.

UTSI 4

{1} Personal Access System, a low-cost mobile phone system.
{2} Internet Protocol Television, interactive TV programs transmitted by internet.
{3} Personal Communication Division, PCD sells handsets other than PAS handsets for markets other than China. PCD was acquired from Audiovox Corporation in November 2004.