UTStarcom Q4 2005 Earnings Conference Call Transcript (UTSI)
February 9, 2006
Fran Barton, Chief Financial Officer
Hong Lu, Chief Executive Officer
Mike Sophie, Chief Operating Officer
Mike Skundgen, Credit Suisse.
Evan Ehrlinson, Bear Stearns.
Darryl Armstrong, Citigroup
Hassan Imam, Thomas Weisel Partners
William Bean, Deutsche Bank
Larry Harris, Oppenheimer
Alan Hille, Lehman Brothers
George Schneider, Jeffries and Company
Tim Long, Bank of America
Welcome to the UTStarcom 2005 4th quarter earnings call. All lines have been placed on mute to prevent any background noise. After these remarks there will be question and answer session. If you would like to ask a question during this time, simply press * then the number 1 on your telephone keypad. If you would like to withdraw your question, press * then the number 2 on your telephone keypad. Thank you. Mr. Barton, you may begin your conference.
Fran Barton, Chief Financial Officer
Thank you Jeremy. Good afternoon and thank you for joining UT Starcom’s 4th quarter and full year 2005 earnings conference call. I’m Fran Barton, UT Starcom’s CFO and I’m please to host today’s call with our CEO Hong LU and our COO Mike Sophie. Hong will begin the call by discussing what has been accomplished during the year. He’ll also share with you out outlook and goals for 2006. Mike will then review business activity in each of our business units and go over the company’s operations. Finally, I will cover our fourth quarter and full year 2005 financial results, and give guidance for the first quarter of 2006.
I’d like to remind everyone that the financial results being reported today are preliminary and are subject to change pending on the investigation of a contract, as discussed in our pres release this afternoon. As mentioned in the release, the audit committee of the board of directors has initiated an independent investigation of revenue recognition on a contract with a customer in India and any other issues related to that contract. This investigation was initiated at the request of management.
In December, management became aware of certain issues that brought into question the timing of revenue recognition for this contract. The contract is with one customer in India and was signed in 2002. From 2003 through 2005, approximately $22 million of revenue was recognized on this contract. The gross profit margin on the contract is less than $1 million. The audit committee will review whether revenue from the contract was recognized in the appropriate quarters. Until they conclude, we cannot say whether corrections are necessary.
We will report our final 2005 financial results in our annual report on form 10K and will reflect any accounting corrections, if necessary.
I’d also like to remind everyone that some of the information we’ll discuss today constitutes forward looking statements. Actual results could differ materially from our current expectations. To understand the risks that could cause results to differ, please refer to the risk factors identified in our latest annual report on form 10K, quarterly reports on form 10Q and current reports on form 8K, which are filed with the SEC. with that, I’ll turn the call over to Hong. Hong?
Hong Lu, Chief Executive Officer
Thank you Fran and thank you everyone for joining us this afternoon. Let me briefly summarize our preliminary financial results.
Revenues for the 4th quarter were $855 million above the guidance provided on November 3, 2005. 4th quarter revenue including $40 PV order from SPV group in Japan, which was included in our guidance.
Our net loss for the quarter was approximately $.17 including one-time charges and gains.
We finished Q4 with just over $1 billion backlog, which is consistent with our third quarter levels.
Our Q4 earnings release also reflects a substantial improvement along several major balance sheet items including cash accounts receivable, inventory and debt.
Fran will provide you more details on our financial results, later on the call. Now I would like to discuss my thoughts on 2005 and 2006.
As you know, 2005 was a difficult year for UT Starcom. We experienced steep declines in our core path market in China and had a revenue lumpiness and lower initial margins in our new geographic and product markets. Having said that, we also spent a lot of time this year on better positioning our product strategy and internal infrastructure to focus on maximizing our opportunity going forward.
Our priority programs in 2005 include corporate restructuring and number two target diversification and three, internal infrastructure improvement. I believe that we achieved significant progress across all initiatives and expect to see tangible results of this work in 2006.
Beginning with restructuring, our restructuring program has been successful and has lead to significant operational savings and balance sheet improvements. Today, we have exceeded cash in each our benchmarks under the restructuring program. Fran will discuss this further, later in the call.
We also made further progress in our diversification strategy in 2005. Throughout the year, we evaluated our initiatives that could offer highest potential return on our investments. Let me quickly run through our target list of addressable markets, which consists of ongoing business and further growth drivers.
The ongoing business category includes, 1) the past business which we will gradually transition to focus on maximizing profit as the market continues to mature, 2) global business which is under the direction of our PCD divisions and 3) our IP based broadband access solutions including IP DSlam, GEPON, and MSTP, our optical transfer product.
Our future growth drivers will center on IPDB, where we believe we are leading the industry in technology and market development and 2) CDMA 2000, which we are pursuing many global opportunities.
Mike will provide you with an update on each of those markets later on the call.
As part of our strategic diversification strategy, we took several steps during the quarter to narrow our focus and redirect resources toward the markets on our high priority list. The few key items include, 1) we signed an agreement to sell our semiconductor design business division to Marvell for approximately $24 million in cash with an additionally $60 million to be paid if we meet certain milestones. By leveraging Marvell’s proven semiconductor capabilities, we’re able to maintain the cross benefits comparable to those achieved by the developing Accenture internally. We expect this deal to close in the first quarter, however, the P&L gain will be prorated over the life of the supply agreement that we have with them. 2) We sold our stakes in Softbank China Holdings for $56.9 million. Softbank China was a venture fund focusing on high tech industry in China. 3) Finally, we complete several additional smaller projects including the divestiture of our WCDMA headsets business in China and a WCDMA RNC system software.
We remain committed to continuously assessing our key markets and may refine our target list further based on the changes in the industry and our expertise in the field.
We also made a substantial progress in improving our infrastructure and streaming our supply chain. Mike will go over our accomplishments on this front. In 2006 we’ll continue to build upon the groundwork laid in 2005. Over the last 12 months, we have been successful in securing initial contracts and trials in such a growth market as IPTV, IP Based CDM200 and MSTP, our optical core network. These are multi-billion dollars markets that hold significant revenue potential for us.
We also recognize that while there are significant opportunities, we also face real challenges. Specifically, with the new markets there is often a timing lag between customer trials and contract leads. As well as a lag between deployments and final customer acceptance and revenue recognitions. This means that in the revenues from a new product, and the new market, will continue to be lumpy in 2006 and will still not fully offset the gap created by declining past sales.
We also face additional challenges of replacing Curitel, one of our key suppliers of the PCD division. We will do this by expanding our relationship with other manufacturers and by introducing more of a UT Starcom based design product into the channels. But, we will still see a gap in the first half of this year for PCD.
These opportunities and challenges define our revenue outlook in 2006.
Let me summarize my thoughts on 2006. This year, we are focused on making incremental improvements across all of our key metrics. You should not expect a quantum leap, but you should see steady progress each quarter. My priority as a CEO for this year is to finish building a reliable business infrastructure that can support consistent growth across multiple product families and geographic markets. This will ensure that we can deliver long term profitabilities for our share holders.
And now, let me turn the call over to Mike Sophie who will give more details on each of our focused business units.
Mike Sophie, Chief Operating Officer.
Thanks Hong. I’ll give a quick update on our business units, wireless infrastructure, broadband infrastructure, PCD and handsets. Then I will give a quick operational update and talk about my goals for 2006 as COO.
Beginning with the PCD division. The PCD division had another strong quarter in Q4. They shipped approximately 1.9 million units with ASPs of approximately $175. In the 4th quarter we began shipping the PPC 6700 to Sprint, Verizon, Alltel, TelUS and to carriers in North America.
The 6700 is the first window-based 5.0-based handset introduced into the market and we have seen a lot of enthusiasm for this product. Shipments of our CDM 7000 product reached approximately 200,000 units at the end of the year with customers such as Sprint. Looking at 2006, as you are aware, Curitel who has historically been our largest supplier, has decided to transition to a direct sales model. In 2006, we’ll continue to sell our existing Curitel models; however, they will gradually represent a smaller percent of the total PCD sales.
To address this change, we have been working to replace Curitel’s product line with our internally manufactured handset as well as those from our manufacturing partners. We have successfully attracted new relationships with vendors such as HTC, KTFT, Casio and HiSense and strengthened our existing partnerships such as Sharp and Toshiba.
Between our partners and us, we have a full product roadmap for 2006 and are in the process of qualifications with all major carriers in North America. Specifically, we expect to introduce two new UT Starcom models in the first half of 2006 and a third in the second half. You should see these models in multiple vendors in North America and volumes should be in the millions of units.
Finally, we are committed to further strengthening our relationship with our existing customers such as Verizon and Sprint in the US and also expanding our sales channels to reach tier 1 customers in Latin America, Asia and Europe.
Moving on to our wireless business, beginning with the past business in China, total path subscriber additions in the 4th quarter were 4.8 million. However, in December, China telecom deducted all non-active path subscribers from the total resulting in net path subscriber additions of 2.4 million in the 4th quarter.
Total path subscriber additions in 2005 were approximately 20 million as compared to net adds of approximately 30 million in 2004.
Cumulative path subscribers have now reached approximately 87 million. During the quarter we shipped approximately 2 million path handsets, bringing the total number of handsets shipped to approximately 11 million in 2005. We also maintained our path handset market share at approximately 53%. We introduced 6 new path models in the 4th quarter and as of December 31st; we had three models in the market which included the new A6, from both UTStarcom and Atheris.
In 2006, we will continue to introduce models with the new A6, with the goal of having over 50% of the volume in the first half and 100% of the volume by year end, using these new chips. These new A6 should reduce our overall path handset costs and improve grow margins as volumes increase throughout 2006.
In 2006 and beyond, we continue to expect cumulate path subscriber growth, though at declining rates over time. We also anticipate moderate declines in infrastructure spending and as such, we will transition the path business going forward to focus on maximizing profitability and cash flows.
On the 3G front in china, we continue to believe that licensing will be awarded in the 2nd half of 2006. though no official timing has been given by the MAI, as discussed on the Q3 call, we have de-emphasized our efforts on the 3G in China in order to focus on areas that we believe will have a better competitive advantage and can generate stronger profitability.
In other wireless infrastructure, we continue to aggressively pursue opportunities for CMA in multiple markets such as India, the US, Latin America and Africa. And in the 4th quarter we announced our in-flight trials of our CDMA infrastructure in conjunction with Boeing. We believe that we’ll be able to demonstrate meaningful contract wins in 2006.
Moving on the broadband infrastructure, beginning with our IPTV solution, we continue to lead the evolution to IPTV in the 4th quarter, announcing the industry’s first commercial contract in China with China Telecomm in Shanghai. In addition, we’ve just signed another IPTV contract with China Telecomm to supply our IPTV solution in the FuZheung province. Details of this will go out via press releases in the next few weeks. We also continue to have many additional trials in China, with both China Telecomm and China Netcom and expect more of them to convert to contracts throughout 2006.
In addition, as Hong mentioned, we recognized revenue on our initial on our initial IPTV contract with Softbank BB in Japan. SBB currently has approximately 100,000 live IPTV subscribers and we believe we will be signing orders in 2006.
In 2006, you should also look for additional IPTV with Tier One carriers in India and Latin America and competitive carriers in Europe and North America. Our broadband access products also continue to gain momentum.
In the 4th quarter, we signed TDslam and MST contracts in India and Taiwan and we strongly believe that as the IPTV market grows around the world, it will create significant need for additional broadband access such as IPDSlam and gigipod solutions. This will present additional opportunities for UTStarcom.
Finally, on the broadband front, we announced earlier this week, the launch of continuity, our fixed mobile convergence solution, which we will debut at the 3GSM show in Barcelona next week.
In conjunction with this launch, we announced our first customer trial with the Tier One carrier, Brazil Telecomm in Brazil. This is a significant first step in establishing ourselves as a leader in fixed mobile convergence.
Now I’ll give a quick update on our operational improvements.
As Hong mentioned in 2005, we made a lot of progress in enhancing our infrastructure and streamlining our supply chain. Some examples of these enhancements include we made significant improvements to our MRP system, and went live with our handset and infrastructure modules in 2005. And we held our first ever global suppliers conference in October and narrowed our strategic supplier base by 25%, which significantly improved the efficiency of our inventory levels and reduced costs.
I would like to close my discussion by outlining some of my goals for 2006, which include 1) to expand our global revenue growth opportunities by adding additional Tier 1 carriers. 2) To continue the optimization of our supply chain organization which will lead to fewer suppliers and lower inventory levels and cost of goods. 3) To continue the worldwide conversion of the oracle system, bring in additional modules and locations live and continuing the automation of our infrastructure. 4) To work with the business units, engineering, purchasing and manufacturing to improve quality across the company and finally to work with our HR team to continue training and developing our management team and employees. With that, I’d like to turn the call over to Fran.
Thanks Mike. First, let me provide some detail on our 4th quarter and full year 2005 results. Then I’ll discuss my initial thoughts on 2006 and give some guidance for Q1.
We closed the fourth quarter with sales of $685 million. This was above our guidance for the quarter, due to higher than expected broadband CPE sales. By business unit, PCD division sales were $348 million in the quarter, slightly exceeding our expectations. Sales for the non-PCD handsets business were approximately $93 million, which was below guidance for the quarter. This was due primarily to parts shortages we experienced in the quarter. Sales for the broadband business were approximately $97 million in the quarter, which were above our expectations. And they included approximately $40 million in IPTV in Japan that was delayed from Q3.
Wireless infrastructure sales were $128 million which were in line with the guidance given for the quarter and service revenues were approximately $19 million for the quarter.
By geography, sales in China represented approximately 30% of total sales in the 4th quarter and this is 32% for the full year 2005. Gross margin. Our overall gross margin dollars for the 4th quarter were approximately $83 million or 12.1% of sales, which was at the low end of our guidance range of 12-15% and compares with margins of 8.5% in the 3rd quarter. By segment, gross margins for the quarter came in as follows:
Gross margins for the personal communications division was 2.9% of sales, which is lower than anticipated due to additional inventory reserves taken in the quarter.
Broadband gross margin was 5.8% of sales, which is also lower than anticipated and includes additional warranty and inventory reserves taken in the quarter.
Wireless infrastructure margin was 38.4% of sales, which reflects improvements in both the path and CDMA gross margins.
Handset margins excluding PCD came in at 9.7% of sales, which declined sequentially primarily as a result of increased path handset rebate approvals taken in the 4th quarter.
Service margins were 49% in the quarter, which is consistent with historical service margins.
Total operating expenses for the 4th quarter were $142 million, which included approximately $11 million in restructuring costs.
SG&A expenses were approximately $70 million or 10% of sales in the quarter.
We were able to collect on older accounts receivable balances in the 4th quarter, which allowed us to reverse about $12 million in reserves for bad debt taken in previous quarters on those same accounts.
In addition, based upon the track record of strong collections over the last 3 quarters now, we’ve updated our estimates as to what level of reserves are required going forward. As such, we further reduced our accounts receivable reserves by an additional $8 million.
R&D expenses were approximately $55 million or 8% of sales in the quarter.
Total income tax expense was $2.5 million for the fourth quarter. The reason we have a tax expense, despite our overall loss position is that we still have taxable profits in certain jurisdictions, such as Japan.
Net interest and other income for the 4th quarter of 2005 was approximately $40 million, which is primarily attributed to a gain of approximately $46 million we recorded on the sale of our stake in the Softbank China fund that Hong mentioned earlier.
A total net loss for the fourth quarter was $21 million or $.17 per share, as compared to a guidance of a loss of $.45-$.55 per share loss.
Transitioning the discussion to the balance sheet, I’d like to reiterate Hong’s point that we’ve now demonstrated three quarters of strong improvements to the balance sheet, which included significant cash collections, reductions in receivables, reductions in inventory and reductions in debt. We’re clearly pleased that we’ve exceeded our expectations in this area.
As of December 31st, our cash and short term investments totaled $658 million, an increase of over $148 million from September 30th.
Our accounts receivable balance at the end of December was approximately $525 million, which represents a reduction of approximately $50 million form the Q3 levels. This is a result of continued strong collections of over $800 million during the quarter. Our DSO was down to 69 days, which compares to 82 days in the third quarter.
We also continue to make improvements to inventory levels and as of the end of December, our total inventory decreased by approximately $50 million to $625 million. Inventory trends for the quarter were 3.7, an improvement of 10% when compared to 3.3 at the end of Q3.
Given the strong collections and the reductions in receivables and inventories, we achieved approximately $126 million of positive cash flow from operations in the fourth quarter. This is the third quarter in a row we’ve generated positive cash from operations.
As such, I’m pleased to report that we generated a total of $210 million in positive cash from operations in full year 2005. We will continue to focus on reductions in overall AR and inventory levels over the coming quarters.
Our total short term debt balance at the end of the fourth quarter was approximately $199 million. During the quarter we repaid approximately $27 million in short term debt. We currently have lines of credit totaling approximately $800 million globally, with various maturity dates over the next 12 months. As these lines become due, we expect to renew them as we have done historically.
During the course of 2005, we made cumulative reductions of approximately $150 million in short term debt and approximately $135 million in long term debt.
Moving on to an update on our restructuring initiatives, I’d like to begin by saying how pleased I am with our restructuring achievements. They represent a real focus by the entire company. As you recall, at the end of the third quarter, we had already exceeded our initial working capital reduction target. To date, we’ve achieved a cumulate reduction in working capital of approximately $231 million since the first quarter of 2005. We also made additional progress in achieving our targeted operational savings. In Q4 our operating expense was approximately $131 million, not including restructuring costs of approximately $11 million incurred in the quarter.
In addition, we reduced headcount by approximately 1,200 employees in the fourth quarter. Our total headcount as of December 31, 2005 was approximately 6,300 employees, down from 8,000 at the beginning of the year.
Finally, before we give our first quarter guidance, I’d like to briefly address UT Starcom’s current evaluation of the effectiveness of its internal controls over financial reporting, as required under the provisions of section 404 of the Sarbanes-Oxley act. The company is still evaluating the findings of this year’s assessment. I will provide a full report with the filing of our 2005 form 10K. Although we believe we’ve made meaningful progress in many of the areas noted as deficiencies in last year’s 10K report, we anticipate certain material weaknesses will continue to exist as of year end, which will require further remediation in 2006. We remain committed to resolving these internal control matters and will discuss our final findings and plans for any further corrective action with our 10K filing.
Before I get into specific guidance for the first quarter of 2006, I’d like to give you my initial thoughts on the full year 2006.
2006 will continue to be a year of transition for UTStarcom. As discussed on the Q3 call, we do believe revenues in 2006 could be down as much as 5-10% from 2005 levels. In addition, we believe that we will have a net loss for the year. We expect to be cash flow neutral from operations for the year but this could fluctuate from quarter to quarter. We believe that Q1 will represent our most challenging quarter and we should see gradual improvements to revenues, margins and profitability each quarter thereafter. We will work towards achieving profitability no later than first half of 2007, but possibly in the fourth quarter of 2006.
Now for Q1 2006 guidance.
For the first quarter of 2006, revenue should be approximately $505-$535 million. By segment, revenue should be as follows:
Revenues from our PCD should contribute about 50% of our total revenues.
Other handsets and CPD revenue should be approximately 15% of total revenues.
Wireless infrastructure revenue should be approximately 20%.
Broadband revenue should be about 10%.
And services would be about the remaining 5%.
Just to say something about backlog. In the fourth quarter, our book to bill ratio was approximately 1.1, excluding adjustments of approximately $100 million taken in the quarter, which resulted in backlog of just over $1 billion at the end of December 31, 2005.
Of our backlog, broadband is approximately 14%, wireless infrastructure is 38%, PCD is approximately 40%, other handsets are approximately 6% and services are approximately 2%. That was our beginning backlog.
First margins. In Q1 consolidated gross margins should be approximately 12-14%. By business unit, gross margins should be as follows:
Broadband margins should be approximately 11-15%.
Wireless infrastructure margins should be approximately 30-35%.
Handset margins should be approximately 12-16% and PCD margins should come in at approximately 4%.
Operating expenses should be approximately $145 million or 28% of sales. This includes approximately $6.3 million in expense associated with stock options due to our recent adoption of Vez123R.
Our Q1 tax expense should be less than $1 million.
GAAP EPS for Q1 is a loss of approximately $.65-$.75. At the current time, we’re planning no impairment or restructuring or any other one-time events in the first quarter.
Cash flow from operations. With respect to cash flows in the first quarter, given our strong collections in the 4th quarter, coupled with our expected loss in the 1st quarter, we’re targeting cash flows from operations to be approximately .
In summary, there were a lot of moving pieces in Q4. But if you strip them all away, I think you’ll see the following picture.
Revenues were slightly above our guidance range given for the quarter, but gross margins were at the low end of the range. Operating expenses are coming down and are on track. EPS adjusted for investments is favorable to guidance. Cash and short term investments are up to $658 million. DSO is down to 69 days from 106 days two quarters ago. Inventory turns are up to 3.7, versus 3.3 two quarters ago. Short term debt is down to $199 million from $265 two quarters ago. Long term debt is down to $275 million from $402 at the end of the first quarter.
Despite these improvements and the improved level of predictability, we have not missed the key points which are: we need to restart our revenue growth and our 2006 quarterly plan reflects this. We need to improve our gross margins and our 2006 quarterly plans address this as well. We need to continue to improve our asset performance and generate positive cash from operations. These improvements will be more moderate in 2006, given the strong improvement we made in 2005.
In short, we know what we need to do and we’re committed to doing it. We expect to deliver incremental improvements in each of these areas every quarter, starting with Q2 of ’06. We will provide you with updates on these metrics on our quarterly calls and encourage our investors to measure our progress one quarter at a time.
With that, I’d like to turn the call over for Q&A. So Jeremy, if you’d set up the Q&A for us.
At this time I’d like to remind everyone in order to ask a question please press * and the number 1 on your telephone keypad. We’ll pause for just a moment to compile the Q&A roster.
Your first question comes from Mike Skundgen with Credit Suisse.
Great thank you. Two questions. First Fran, you mentioned that the upside for revenues relative to guidance for Q4 came from broadband CPD. I wanted to see if you could expand specifically on where that came from in a little more detail. And second, if we could with the Q1 guidance for sales get some sense of the geographic trends you’re expecting in Q1.
Okay Mike. Yeah, thanks. In terms of the revenue upside in broadband, it was basically the lower end stuff, set-top boxes and the TREO product we have. So, the margins there are a little less than the average for the overall broadband business but that’s where we saw the upside. And, in terms of Q1 geographic guidance. Let me think about that one for a second. I may have to get back to you.
I can help a little bit Mike. We normally have the seasonality in Q1 which is global in telecomm. But, specifically with the Chinese New Year, in China there’s always a downturn in China. And then, internationally, we’re seeing those revenues a little bit lower than Q4, primarily given that we have some large revenue recognition in the fourth quarter for the IPTV product in Japan.
Great. Thanks. And the low end set top boxes in Q4, was that in Japan or into another market?
Mainly in Japan.
Your next question comes from Evan Ehrlinson, with Bear Stearns.
Thank you very much. Two questions for you. Number one on the SG&A side, if you could give us a breakdown on the Sarbanes-Oxley and supply chain management software-related expense for Q4 that would be great. And also, the outlook for 2006. number two question is related to talent management resources and the outlook for 2006 as you shift your business focus and the revenue outlook is somewhat uncertain, what do you foresee as the challenges for your company and how do you expect to address them? Thank you.
Okay, maybe I’ll take the first one Evan. In terms of…I don’t have specific S-OX expenses, but these things are measured in the millions of dollars, several million dollars from our consultants. Frankly, just our auditors as well, the amount of work that they have to go through. We don’t actually keep track of the effort of our own internal people, which would also add up to several million dollars. But overall, there are some…we would hope, I wouldn’t exactly call them one-time expenses because we’ll need to do them again in Q1 to finish this thing and parts of next year, but, certainly not an ongoing expense. So, the year end audit, S-OX, investigations, legal expenses, we’ve got a number, several million of each of those in our Q4 expenses.
Regarding your second question on the challenges let me give first thoughts and then Mike if you want to add some more. First, is the international sales outside of China, we do have very early experience. In other words, we don’t have a lot of the sales person in the field. So, we will have to work very selective accounts and we want to target the Tier 1 and usually Tier 1 will be taking a longer time than the others. So we have seen very, very good initial success, particularly in Asia pacific areas, in the Philippines, in Taiwan, in Korea and also we see in Thailand, as well. So those are very, very positive. We have been getting our name out. But they are taking a much longer time than we had anticipated. In other areas, that definitely is in which is in Central America and Latin America areas that we are in Mexico, in Brazil, we have also seen very good attractions. We are facing more difficulties in European areas, which I think we have not yet have any Tier 1 based customers at this moment and this remains a challenge for us. And, as well as the North America…we do have some Tier 1 accounts, but they are more of the handsets or PDSM type, but not broadband or our existing wireless infrastructures and that’s going to take a little bit more time to introduce. And another part is that our people and training…so we need to do a lot more human resources and adopting to that kind of challenges; those are our major challenges in 2006.
I maybe misunderstood part of your question but you were talking a little bit around visibility in Q1. And I think as Fran and Hong both mentioned, we have approximately $1 billion in backlogs. I think we’ve got pretty high visibility of where the revenues are coming from in the first part of 2006. and just adding to Hong’s comment I think we really are moving forward with a combination of direct as well as an indirect partner strategy on a global basis and I think we’re making some pretty good strides in the markets that Hong mentioned, in EMEA and in North America on the infrastructure side I think we just have to continue to work at it.
Your next question comes from Jeff Kaval with Lehman Brothers.
Thanks very much team. I have two questions. The first is, could you talk a little bit about the factors that lead to a preliminary release and what things need to be tied up before we get the final numbers? And secondly, Fran for you, it sounds as though you’re looking for cash flow neutral for next year. It sounds as though EPS and the net income level will be off. It sounds as though you are looking for continued improvement in the balance sheet for next year and I’m wondering if you could talk a little bit about where you might find that, the DSOs as you suggest have done very well over the past 3 quarters.
Okay Jeff, sure, thanks. On the first question, what happened here…management towards the end of December became aware of a transaction from several years ago and in looking at that transaction we were concerned whether the revenue was processed properly at the time. We’ve brought this to the attention of the audit committee and recommended that they initiate an independent investigation. They agreed with that and did start that investigation recently. It’s still going on. We are not…that report will go back to the audit committee, so we’re not reviewing that work ourselves. Although we’re certainly participating in the data collection. When that investigation is concluded, we will take the appropriate actions and because of that, we have to leave open the fact that if it turns our that there need to be corrections made that certain time periods, including Q4 of 2005, then that is one of the reasons, the main reason, why we’re referring to these numbers as preliminary. We’ve obviously closed our books but we have this investigation to be completed.
That’s the full reason the, Fran?
That’s the primary reason. A small ancillary reason is because we’ve put a little bit of time into this, we want to also be sure that between our auditors and ourselves that the stuff we’ve done well and that we’ve just reported gets time to be checked out. So, we’re mindful of the fact that we’re all busy burning the candle at both ends. And that’s an offshoot of that reason. But those are the sole reasons, yes.
Okay. And then on the balance sheet improvement, where should we look for that in 2006?
Sure. So balance sheet improvements, we’re continuing to set DSO targets and inventory turns targets. We’re trying to knock a few more days off of our current. We get down as I said to 69 days, which I haven’t figure out how many quarters or years; that’s the best performance in some time. But we’re still trying to get down possibly another almost 10% better in turns for next year. And in terms of inventory we’d like to do even more than the 10% turns improvement for next year, maybe 10-15% improvement. So, we’re going to continue to hammer away at those two areas operationally. We believe there’s opportunity there to manage it more effectively with some of the infrastructure and reporting and process systems that Mike referred to earlier. So, we think therefore, despite the loss, we ought to be able to offset that cash flow with operational asset improvements. We just, you know, between us guys we’re also trying to do better than that. But in terms of guidance, I think setting a neutral tone is probably appropriate at this time.
Wonderful, thank you very much Fran.
Your next question comes from Darryl Armstrong with Citigroup.
I have 2 questions. The first one, relative to the loss of the supply agreement with Curitel, given the fact that Curitel is going direct and they’re targeting many of your existing customers, what plans do you have in place and how much confidence do you have that once you ramp up your supply agreements in the second half that you’ll be able to recapture that share? And then I have a follow up.
Yeah Darryl, this is Mike, I’ll start with that. First of all, you know that the PCD group, which was formerly AudioVox, has been in the business group for 20 years. They’ve developed very strong relationships with the customers over those years. They do an excellent job in terms of product marketing, distribution, repair. Their providing quite a bit of value added. If you look at the historical results as well, you know the suppliers have changed quite radically over time. If you go back two, three years ago, Toshiba was the primary supplier of handsets. And then you saw Curitel come in with some very good models and their volumes went way up. So, you’ve got to take the perspective that the average shelf life of a handset is about 9 months in the US. The design cycle is typically longer than that. And so you can see handsets move very rapidly between high volume to not being successful there. Now what the group has done is that we’ve continued to add suppliers, as I mentioned. We’ve got some great relationships with existing people like Sharp, Toshiba. We’ve got newer suppliers like HiSense, Casio, HTC. They’ve got some very good models. Plus our own UTStarcom models are gaining very good acceptance with the carriers. And so, it’s a lot more than just a single supplier to make that business a success and, I think we do remain confident that we will be .
If I think I heard you correctly that if you would access the handset business in China, how much of that decision is driven by your ability to be competitive within in China, versus your assessment of the role that WPD will play from a 3G perspective within that country?
Let me try to answer that one. First of all, we believe from our experience, that WCDMA, whoever can supply that amount of equipment on a worldwide basis there’s about 13 companies, including UTStarcom. And we know that it’s going to be becoming bloodshed and it’s going to be a very price competitive. Second is we have not yet seen anybody else in the entire world has a successful 3G operation basis in making a profit, other than CDMA2000 and all the 3G has really not seen a significant improvement in their profitabilities, including in Japan. And so, particularly with other companies, we certainly do not believe that they have been able to demonstrate. Therefore, we really see there’s really no winning situation being a operator, we’re not likely to be a profitable business and in the meantime that everybody else is going to be very much one or two supplier equipment. So, UT Starcom has decided it’s not in our best interest to stay in that business, particularly in China.
I also wanted to tell you only if China as a government gave the license earlier, then we would benefit tremendously, because we are one of the earliest companies who can provide end-to-end solutions, except we didn’t have handsets. But we have a full solution for the infrastructure basis. Unfortunately, the government did not really go for it earlier so we have just decided to withdraw.
Thanks for answering my questions.
Your next question comes from Hassan Imam with Thomas Weisel partners.
Good evening, this is actually Octavia Pappas in for Hassan Imam. I have two questions. My first question has to do with the IPTV prospects in China. So far, there’s been no regulatory constraints in terms of licenses and as far as I know this continues to be ongoing. I want to see if you think that part of the restructuring; the Chinese government is going to issue kind of broader nationwide licenses for IPTV. And if that’s not the case, are your current trials big enough to offset the decline in path? And the second question has to do with China. That comes under a scenario where they would not get the 2G network and they would keep their Path. What hurdles would you have to overcome for Path to become a compatible with PBS CBM or other 3G networks or would you need kind of a dual mode handset to allow roaming between the 3G and the Path network? Thank you.
About the IPTV, we think the Chinese government was going to take a little time. We believe they will go first with ShangHai and then HarBing and gradually they’ll expand it to some of the areas in Fu-Jin and very selectively. And they are observing, making sure that every department and every ministry’s benefit has been taken into consideration. In other words, does the broadcasting and also the telecomm sectors that they wanted to make sure that everything is working out fine. And, China is a very unique in terms of the government and also controlling the content itself. So, they also have much easier area to decide who will be able to provide the content, which I think is much…one thing has decided how you’re going to progress on IPTV they’re going to explore it much faster, compared to say United States or in Japan, which I think everybody’s talking about how the copyright issues is going to be and how do you compensate some of those…the benefit to the content providers, including actors and actresses and so forth. So that is a lot more complicated issues in other parts of the world. Once China has decided that it’s going to be going full speed and much faster. So, we are not expecting IPTV itself is going to fill the gap in Path decline, comparatively speaking, but we see the market is going to start…we’re expecting anywhere between 10-20 cities and we hope we will be able to get the majority of those cities in 2006. And 2007 will actually expand much faster and 2008 we’ll probably peak. As far as your second question on China Telecomm and China Netcom, if they were going to be actually getting a 2G license or whatnot. At this moment, we don’t know. But the rumor shows that they will be likely to get the SCDMA type of a license and that’s what we were told. And if that’s the case then we definitely would consider some to be able to over a period of time that we’ll be able to supply the Path and the TDSCDMA with them. Now it also will take them very long time for anybody to get into the infrastructure business. They will have to take at least 3 years to really cover, improve the coverage. So before then, they’ll very much have to depend on Path infrastructures.
Your next question comes from William Bean with Deutsche Bank.
Yes. I’m still confused a little bit on the China IPTV scenario. We’ve seen a lot of press releases from China Telecomm and I guess a few from China Netcom. Can you just give us a sense of what your share is in terms of the announced contract lines? And where do you think that will go?
Well, William. First of all, there are only two official government licenses and we’ve got both. So, in the market share we’ve got 100% for the legal ones. And, as far as the … in Shanghai we’ve got 5,000 and once they’ve been up and I’m sure they’ll expand it a lot bigger, than the 5,000. And we do have Harbing, which I think we mentioned has been exceeding 50,000 and actually they are taking some revenue from the customers as well. And we do believe that they will open up Fu-jin province and Gwan-Dong province and San-Shee province. And those are the areas that we know and we have signed with China Telecomm with the mini-cities more than what we have stated. But there are only 2 official ones and the rest of them are not official.
Okay. Just because I think that some of these trial networks son the PHS side. They were put out there and they became official much later and it seems like IPTV will be the same thing where we’re getting 500,000 line orders in southern China and it will just get rolled out and then they’ll worry about the government approvals later. Do you think that will happen?
No, it’s not. It has to happen…it is really not depending on just the China Telecomm, it requires content and the broadcasting it totally much more controlled and so they cannot just do the content without official . So they cannot do half a million.
Okay. So the China Telecomm media reports are incorrect then?
I have not…
In terms of the PCD site, I just want to get kind of a breakdown between high, medium smart phones at the end of ’05 and how you see that will play out over ’06?
I don’t have a really good split for you here; we’ll have to get back to you on that. Smart phones are small in volume. You’re talking about like the pocket PC?
Yeah, that is fairly small percent, but there are on the basic cell phones more towards the high end and that’s why their ASP is around $175.
$175 is much higher than the average norm. The great majority of shipment is below $100 in the entire USA.
And can you give us a sense of where we are in terms of the supplier breakdown and how much is in house?
At this point I would tell you that the supplier base, the vast majority for 2005. As we’re going to 2006 I think it moves more into…we’re probably targeting about a third to be UTStarcom designed and manufactured handsets and then the other 2/3 would be split between the variety of the suppliers. For the full year.
Your next question comes from Larry Harris with Oppenheimer.
Yes. A couple of questions, just sort of following up on that with respect to your own sourced handsets, the CDM7000, I’ve just seen it in one Sprint store so far. What’s the schedule that we could expect to see broader distribution of that model in North America?
We have actually shipped out a couple of hundred thousand. I think they’re still delivering. Actually, we have more demand than we can ship. And, before we introduce others, we expect to ship another 300,000 for the 7000. And there we’re going to introduce 2 new models for the, our own model name is 725 and 775 and those will be coming in in Q2 timeframes.
I understand. And any thoughts with respect to the EBDO type cards that you supply for Verizon and other carriers? Are you seeing a lot of demand for those?
Yes. It’s a very high demand and that has been fairly continued by getting good responses in the market. And so we see demand is quite strong.
Would you say you have a pretty good market share there with say, carriers like Verizon?
We believe so.
Alright, thank you.
Your next question comes from Alan Hille with Lehman Brothers.
Yeah hi gentleman. On the side overall. Could you kind of force rank your 3G revenue opportunities in ’06 and ’07 across CDMA, which I’m assuming your trialing ? And then just wondering if you have any thoughts forming with regard to YMAX and possibly leveraging some of the similarities between PHS and YMAX as TDD based technologies. Thanks.
I think every segment of the markets are different. For instance mobile got the license from Japanese government for the very specific TDD version of their frequencies. And if you really look around when is technology available, and TDCDMA is for the data purposes, the best solution. And we also see that type of environment is also happening in spotty areas in Europe. For instance, we are active in UK and some parts of the Norwegian areas, geographical areas as well, have some requirements because of certain operators got the license for those specific frequencies. Now, with the time involved, definitely we are going to be looking to what other technology is going to come alive, including the YMAX. We are very familiar with the technology so, it is IP-based technology and we are probably more familiar than other competitors since our i-Path has been IP backboned. Interesting enough, YMAX, the coverage area versus our Path is very uniquely similar. So we know how to handle that kind of macro base-stations much better than the others because they have similar coverage and they usually take up a lot of base stations to cover any given cities. And, potentially whoever has the benefit of those real estate, will benefit. I don’t know if you understand what I’m trying to say. The base station, the cell sites. And if you have the sites already and then whoever has the sites, they’ll have to reconstruct it and that itself is a significant benefit. And we will be able to significantly improve that situation with whoever is going to get the license for the YMAX in the future. So we have also look into those technology as well. We are actively studying those.
That’s really helpful, Hong. Just one follow up question. Let’s just say by 2007 across the many mobile paradigms you guys have developed, what specific…which one of the four or five should we really be focusing on the greatest opportunity that TDCDMA, WDCMA, CMA2000, etc.?
We will be focused on CDMA2000. It is a very uniquely positioned product. We have been active in some parts of the world. Our customer has operation in Long Island, but their customers are in Africa. Or their could be in somewhere else in north America or in Alaska, that their core network is residing in Long Island but they will be able to manage their customer remotely, using our IP technology. Those are some things that are unique and we’re the only company that has it. So we’ll be significantly focused on that. And of course TDCDMA, we have a customer base and we are very uniquely positioned in that product because we believe we’re the only, the commercially available in large scale deployment. We’re the only company today that has that solution.
Your next question comes from George Schneider with Jeffries and Company.
Thanks guys. Quick question about the Path business. I think your prior guidance calls for the Path business to be down slightly in 2006, relative to ’05. if I look at your guidance for the wireless business, I think you said it would be about 20% of sales in Q1, it kind of works out against the topline guidance and kind of suggests you’d be tracking for a number that would be lower than what was your prior guidance for full year Path. Can you talk about what the new guidance on full year Path should be and how we should look at that going forward? Thanks.
I’ll let Fran comment on guidance. Let me just kind of highlight that Q1 is not a good benchmark for the Path business typically in China for a full year, given the China New Year. If you look at our results historically, China has always been down pretty drastically in Q1.
I think it depends on. I think it’s more dynamically changing based on what is…what kind of technology is there. 3G is it going to be a WDCMA, is it going to be a TDSCDMA and based on those and the operator, we’ll react totally differently. Now one good indication is that we have higher demand in the Q4 and we couldn’t deliver enough handsets. I mean, both handsets and our base stations. So that has actually shown that we have higher demand than we anticipated. Moving into Q3 to Q4. So, overall, it is hard to comment and we are from quarter to quarter still looking at the market demand and when we start making our forecast and it could be very widely one or the other. But I can tell you right now we have more orders than we could deliver to the market today.
So then is it fair to say that Path business down slightly is still the Packard guidance for the full year?
Yes. So IPCDMA is offsetting that in the opposite direction, going up.
Your next question comes from Tim Long of Bank of America.
I think we’re going to make this the last question because I think we’re using up everybody’s time. So we’ll take one more question from Tim and then we’ll break it there. Thanks.
Okay. This is Chanie Lu, calling in for Tim Long. Actually my question is regarding the PCZ gross margin, as you try to transition from the AudioVox to new suppliers, are you looking for a gross margin of about 4% which you have by now?
Yeah, gross margins will improve as we change the mix, as Mike talked about earlier. That is to say, more of our own proprietary product will definitely increase the gross margins. In the short term, we’ll have increased R&D offsetting that. So, in the first couple of quarters you won’t see that flowing through the bottom line. But it will be improved sequentially gross margins, due to our internal, as our internal product proportion of the total grows. And, I think that answers your question.
And also, proper new supplier agreement, with new suppliers…is that going to be 4% or could it be higher?
I’m not sure I caught the question.
You’re asking are the news suppliers, how are the margins on the new suppliers relative to Curitel?
I think what we have found as we’ve broadened out the supplier base as well as internal handsets; both of those can contribute to increasing margins.
So we’ll expect those margins to go up throughout ’06 from the 4 range towards the 6 range.
I think as another way to look at it. I don’t think anybody in the business model, 4% is absolutely very difficult for anybody to come in to distribute their own products. We definitely think there’s a lot more room for us to improve on the 4% areas.
We want to thank everybody for tuning in today and we will see you next quarter. Thank you all very much.
That concludes today’s UT Starcom 2005 4th quarter earnings call, you may now disconnect.