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Investing in UTStarcom (NASDAQ:UTSI) has been a nightmare for shareholders who have held this stock between 2003 and today. The stock had steadily dropped from the low $40s per share to just $3 as of Tuesday November 6th , 2007, bringing the company's market cap from over $5 billion dollars to the $350 million range, or over $4.7 billion in lost shareholder wealth in the last four years.

The massive decline in the stock price is the result of a multitude of events, some external and some self inflected. The major blow to the company performance has been the phasing out of its Personal Access Technology (PAS) by the Chinese telecom operators (China Telecom (NYSE:CHA) and China Netcom (NYSEARCA:CN); in the late 90s and early 2000s, the Chinese fixed-line telecom players opted to use UTStarcom's Japanese borrowed technology as a away to offer limited mobility to their clients since they lacked a mobile license; as a result, demand for the low price PAS exploded, reaching at a certain point over 20% of the fixed-line operators voice revenues.

However by late 2004, as price for regular mobile service declined and 3G licensing to the fixed-line operators was looming, the Chinese fixed-line operators sharply cut their spending on PAS, as they diverted their resources toward 3G, this in result caused a significant decline in UTStarcom PAS revenues, which declined from over $2 Billion dollar by the end of 2004 to under $400 million dollar today. To UTStarcom's credit, the company did try to penetrate new markets with its PAS technology, as well as diversify into new business lines. To that end the company purchased the PDSN assets of 3Com (COMS) in 2003 for $100 million dollars; additionally it purchased the communication division of Audiovoxx (NASDAQ:VOXX) for $170 million in 2004. The company also expanded its IP-CDMA portfolio by the purchase of the assets of the Vancouver based Telos for $30 million and the assets of the Korea based Hyundai Syscomm for $14 million. Furthermore the company undertook a number of smaller acquisitions in the broadband space: RollingStream systems an IPTV equipment company and Xebeo an optical switching company, both acquired in 2003, and Pedestal Networks an ADSL2 technology company, purchased in 2005.

Despite the above efforts, the company was unable to diversify substantially from PAS, while acquisitions such as the acquisition of Audiovoxx communication segment brought in over $1.3 billion in revenues. Those revenues were very low margin and low growth, and the company failed to enhance the business margins by offering its own designed handsets.

In light of the above, the company suffered growing losses, as the company's business structure was not prepared for the loss of the high margin PAS revenues. In response, the company under took a re-organization in 2005 that lead to the firing of 17% of its employees or over 1400 staff, yet that was not enough; the company continued to register substantial losses with over 487m loss in 2005 (largely due to substantial write offs of assets) and a loss of over 117m in 2006 largely due to the continued loss of the PAS business and ever shrinking gross profit margins.

In conjunction with the operational challenges, the company faced a number of investigations relating to multiple issues ranging from options backdating, to revenue recognitions, to possible violations of SEC regulations regarding insider selling by the CEO & Co-founder Mr. Hung Lu (which was settled this summer). Due to those various regulatory issues, the company was obliged to restate several years worth of financial statements and delay its quarterly and annual filings, a situation that put it in technical defaults with its bond holders and exposed it to the risk of delisting from the NASDAQ national market.

Finally, the last straw came in June 2007, as the company ended the employment of Mr. Ying Wu, the company's co-founder and COO of the China operations. It also put an end to the work of the committee in charge of finding a "strategic alternative" a committee that was lead by Mr. Ying in collaboration with Merrill Lynch. The termination of the strategic review had a very strong negative effect on the stock price.

Yet despite all the above, I believe that there is a case to be made for UTStarcom, and the reasoning goes as follows:

Regulatory issues

In 2005, the company hired a new CFO Mr. Fran Barton, after firing the old CFO Mike Sophie, since under his watch several of the accounting issues took place, Mr. Barton has worked diligently to clean the books and establishing stringent internal control mechanisms; finally, and due to his efforts, the company is current with its filings and all prior accounting errors have been corrected and financial statements restated.

Business issues

In July 2007, the board hired a new COO, Mr. Peter Blackmore (who is set to become the company CEO sometime in 2008). Mr. Blackmore has extensive experience in managing multi-national companies and has held several senior positions at Compaq, Hewlett-Packard and Unisys corporations, Mr. Blackmore has undertaken the following re-organization:

- Downsizing the work force by 11% or 700 employees by the 4Q of 2007, yielding an annual savings of about 20 million dollars in operating costs.

- Improving procurement and supply chain management, with a goal of 50 million dollars in annual savings starting in 1Q of 2008.-Reorganizing the business in core & none-core business units:

1. Core Business Units: Broadband & IPTV, inclusive of softswitches, access devices, and optical transport.

2. None-Core business units:

  • Personal Communications Division, which sells handsets other than PAS
  • Terminal Business Units, developing handsets and related devices for telematics
  • IP CDMA
  • A "custom solutions" business unit for areas such as IP messaging and transaction gaeways.

3. Unclassified: Personal Access Division inclusive of PAS infrastructure and PAS handsets.

It is safe to assume from the above division that the company is setting up the none-core business units to be divested. While management did not openly state that goal, the current structure leaves no doubt that the company is planning to focus on a specific area for growth in the future and divest none-essential areas to raise cash and improve profitability.

Value of the None-core assets

It is hard to pin point an exact value on UTStarcom diverse collection of none-core assets, but to get an approximation, it is good to look at the price the company paid for those assets:

  • PCD Division: This division was purchased from Audiovoxx in November 2004, for 170 million dollars. The division business has grown slightly since then and has maintained constant margins; it is safe to assume that UTStarcom can sale the business for a similar price.
  • Terminal Business: The company terminal and handsets business was partially developed in-house and partially built through the acquisition of Giga Telecom of Korea for $19 million dollars in October 2004; it is safe to assume the value of the handsets business to be in the $20 million dollars range.
  • IP-CDMA, CDMA2000 & PDSN: This business was built through the acquisition of the assets of Commworks from 3COM in March 2003 for 100 million dollars, and the acquisition of Telos based in Vancouver, Canada for $30 million dollar in May 2004, as well as the acquisition of the CDMA assets of Hyundai Syscomm in April 2004 for 14 million dollars. This is the hardest segment to value since Commworks seems to have lost its edge in PDSN after the UTStarcom acquisition due to aggressive competition from Starent (NYSE:STAR) and Cisco Systems (NASDAQ:CSCO); thus, to be on the safe side, the value of the CDMA assets would be put at $100 million, despite an initial investment of $150 million.

The total approximate value of the above assets is $290 million dollars.

Balance Sheet

Despite the difficulties the company went through, the company continues to have a strong balance sheet with over $530 million in cash and short term investments, and over $100 million dollars in a little known portfolio of securities in several companies, most notably Gemdale in China and Infinera in the US, against which the company has total short term debt of $275 million dollars in convertible bonds due in March 2008 and $100 million dollars in short term bank borrowing.

Strong Position in Broadband & IPTV

UTStarcom is one of the leading companies in IPTV. The company had a head start in the industry by working closely with Softbank BB in Japan, which was one of the first companies to bet on Triple play, and has been working with UTStarcom since 2001. (It is worth noting that Softbank has been a long time shareholder in UTStarcom). Being a first mover in this market and due to the company's traditional focus on IP technology and its end- to-end integrated IPTV solution, the company managed to capture 60% of the Chinese IPTV market by signing multiple contracts with China Telecom & China Netcom; additionally the company scored several big contracts with in the Indian market, most notably with MTNL & Bharti Airtel. Furthermore, the company has signed several Next Generation Networks contracts based on its optical transport technology, most notably in India & the Philippines.

Focus on new areas of growth

In addition to IPTV, the company plans to expand on new fast growing markets such as Video Surveillance over IP [IPVS] and Video over IP for educational purposes. ccording to a recent report from the research firm RNCOS, the global video surveillance market is expected to grow at CAGR of 39.6% over the next 5 years, reaching 12 billion dollar by 2010.

So what does the future hold for UTStarcom? Based on the above thesis, UTStarcom should substantially strengthen its balance sheet and liquidity in the next 12 months as it liquidates its securities portfolio and divests none-core assets, raising close to $400 million in the process, adding to its strong $530 million cash position. As a result of the re-organization and streamlining of the operations, the company will likely reduce its current cash burn rate and focus its operations on the fastest growing segments of its business, being broadband and IPTV, as it continues to gain substantial market share especially in IPTV in the world's fastest growing communication markets, China & India.

Finally, despite PAS declining sales, the division remain profitable and will be a source of much needed cash flow for several years, as it will take some time for the Chinese telecom operators to phase out a service that continues to represent a sizable portion of their fixed line voice revenues.

At its current valuation of $350 million, UTStarcom is trading under its $6 book value, or approximately trading at its cash value (inclusive of its securities portfolio), meaning an investment now would offer you UTStarcom collection of assets free of charge.

While the future success of UTStarcom as a stand-alone company is by all means not assured, the company's core business presents a valuable technology portfolio and a precious relationships portfolio with Asia's biggest and best telecom companies, making the company an interesting take-over play for the likes of Ericsson (NASDAQ:ERIC), Alcatel-Lucent (ALA) and even Cisco Systems (CSCO), as most of these companies continue to expand into IPTV and continue to expand into Asia.

Disclosure, the author is holding UTStarcom shares at the moment of writing.

Source: The Long Case for UTStarcom