A few months ago I dissected one of the small technology companies, Embarcadero Technology (EMBT). I speculated that it could be bought for $8 a share based on these factors:
- It is a stable and profitable business.
- It has large amount of cash sitting on its balance sheet.
- It has a niche market but is not big enough to fully utilize its sales force and operational resources.
Luckily for me the buyout speculation was born out later with a price tag of $8.38 per share. Will I get lucky again? I can only speculate. But numbers on another company I follow are becoming intriguing.
The company in question is UTStarcom (UTSI). It was high flying in the $40s until the party ended and it crashed all the way to $5. The party crusher was the abrupt slow-down of the PAS market in China. UTSI owns more than 50% of the PAS market in China, where traditional telecoms offer city-wide mobile service at an affordable rate. In anticipation of big spendings on 3G, Chinese telecoms cut down on PAS investment, causing revenues to shrink and margins to drop
among PAS vendors.
Now things appear to be stablizing based on these factors:
- Chinese telecoms’ PAS investment has been stablized at the cutback level.
- The company cut operation expense substantially by discontinuing non-core projects and reducing workforce.
- The company tightened its internal control significantly by bringing on a new CFO.
- The company cleaned up its balance sheet, increased its cash position to $650M, brought LT debt from $400M down to about $300M, and wrote off almost all of the goodwills.
- The company’s IPTV technology seems to pick up steam in the early phase deployments in several Chinese cities. It is now the undisputed leader in China’s IPTV market.
The stablization can be seen from the following table. The company is on the verge of cash flow even, even though its reported earning are quite negative. It is unlikely that any substantial improvement can come from increased reven ue or a much higher gross margin. Mass market adoption of IPTV is still years away. But if the company merges with or is acquired by another party, substantial savings may be available from the $80M/quarter Selling and G&A expenses, and the $45M/quarter R&D expenses. It is not inconceivable to save $20M/quarter within the combined entity without hurting the core strength of the company. That translates into almost $60M operating income a year, or about $130M EBITDA a year. Based on this number UTSI’s current enterprise value of $900M is quite fairly valued. Of course, if some company is really eager to merge, I wouldn’t be surprised to see an offer of $10 to $11 a share. But I don’t see a decent arbitrage opportunity existing at the current $9.50 a share level.
|UTStarcom (UTSI): market capitalization $1.15B (as of 10/06/2006)|
|Free Cash Flow ($M)||(13)||4||(33)||(91)||(68)||36|
In the end, the talk of M&A is just a speculation. One of the obstacles to a merger or acquisition is the unique culture of UTSI. Even though it is a U.S. company, its core market and core employee base are in China. It is essentially a Chinese company at its core. For a foreign company to buy it, integrating the company successfully could be a big problem, especially if the Chinese government preceives it to be a threat to national interests. For a Chinese company to buy it, there are other problems to overcome, namely the cultural difference with a U.S. management team and the new set of laws and regulations to deal with. If these obstacles can somehow be dealt with successfully, a buyout of UTSI could well make sense.