UTStarcom Holdings Corp (UTSI) 2004 Q2 法說會逐字稿

Good afternoon. My name is Brenda and I will be your conference facilitator. At this time, I would like to welcome everyone to the UTStarcom second-quarter 2004 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (OPERATOR INSTRUCTIONS) I would now like to turn the call over to Mr. Mike Sophie, CFO of UTStarcom. Mr. Sophie, you may begin.

Thank you, Brenda. Good afternoon, everybody, and thank you for joining UTStarcom's second-quarter 2004 earnings conference call. I am Mike Sophie and I'm pleased to host today's call with our CEO, Hong Lu.

Hong will begin the call this afternoon by discussing UTStarcom's vision and strategy. Then he will turn the call over to me for a detailed financial review of Q2 2004, as well as guidance for Q3 and the full year. Afterwards, we will open the call for Q&A. We have a lot of information and updates to share with you today, so our prepared comments will go a little bit long. And as a result, we request that questions really be held to one each so that more people can participate in the call today.

Before we continue, I would like to remind everyone that some of the information we will 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 risk factors identified in our latest annual report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, which are filed with the Securities and Exchange Commission. With that, I will turn the call over to Hong.

Thank you, Mike. Good afternoon and thank you for joining us today. For some time now, I have laid out my vision of UTStarcom for the investment community. In this vision, UTStarcom evolved from a successful company that has dominated the China market with the PAS technology to one of the world's leading telecom solution providers.

In the past year, we entered into a number of new markets through the combination of organic growth and strategic acquisitions. I believe that the next six months will be crucial transition period for UTStarcom as we add those new initiatives into our core business and immerge as a truly diversified global telecom solution provider.

Of primary importance, we needed to expand our internal operation to keep up with our rapid external growth. We especially need to improve our international operations. We anticipated that non-China sales will contribute about 50 percent of our total revenue by year 2006. We recognize that this transition involves many risks and challenges; however, I believe the success we can achieve is worth those challenges.

The second quarter represents both some of our best success to date and some of the most difficult challenges we have had to face. I will start the call today with an overview of what went well in the quarter; then I share with you the things that need to be improved. I will also share with you how we plan to make those improvements.

Here is what went well in Q2. First, revenue in the second quarter exceeded guidance and came in at 689.6 million. This represents a 70 percent increase year-over-year. Our profitability remains strong, though we came in just below estimates at 32 cents per share.

Second, we maintained market share leadership and saw strong demand for our core product in China. Third, we are gaining momentum in the international diversification strategy, as evidenced by this year's booking and contract announcements. These include the building out of PAS network outside of China, as well as major contract wins in our non-PAS product lines.

Geographic and the product diversity are key components of our long-term growth strategy. We have projected 600 million in international revenues outside of China in 2004. We expect 2 billion in international revenue in 2005. International bookings on our core business also typically bring higher gross margin of between 45 and 50 percent.

International bookings remain on track to make our revenue goal over (ph) 2004. As of June 30, we have booked more than 400 million in international contracts; nearly 300 million were booked in Q2 alone. This is greater than our total international revenues for all of the year 2003.

Now I would like to provide you with some more color on those developments. I will begin with the latest PAS development in China. Last month, we announced a large contract with China Telecom to deploy PAS in Shanghai, the largest, most advanced city in China. This is just one of over 200 million PAS contracts in China that we announced during the second quarter. UTStarcom PAS servers are now available in 180 cities, including 19 provincial capitals and in 27 provinces throughout mainland China. We dominate the PAS market in China with between 55 and 60 percent market share for both infrastructure and handsets.

Total PAS subscribers on UTStarcom's networks surpassed 30 million in the second quarter. Total PAS subscribers in China reached nearly 54 million at the end of the second quarter. Our key customers remain committed to growing their PAS business, as China Telecom stated at our recent analysts' day. We believe there will be 65 to 70 million PAS subscribers by the end of year 2004, and up to 100 million by the year end of 2005.

The success of PAS is not limited to China alone. We are replicating our proven PAS deployment model in other emerging markets. In Q2, we announced a multi-million dollar expansion contract with FITEL in Taiwan. We also began volume shipment to Thailand and several countries in Africa during the quarter, including Mali, Swaziland and Cameroon.

In Honduras, President Maduro made the first commercial call on our PAS network as our customer multi-phone officially launched its service on July 12. We currently have a commercial use on a network and are scaling it to accommodating up to 150,000 initial subscribers. More than 200,000 people in Honduras are currently on the waiting list to receive phone services. We believe PAS is the most efficient and cost-effective way to bring the basic telephony to the people in Honduras.

In addition, we added to our PAS footprint in Latin America. We announced our first (indiscernible) in Chile to build out the network in 19 cities with Telefonica del Sur.

Our success is not limited to PAS alone. We have made significant strides with our other key wireless and wireline solutions. Global interest in our broadband infrastructure product is extremely strong. During the quarter, we signed several key contracts and achieved other milestones, such as we signed an expansion contract for our IP-DSLAM platform in Japan to support Yahoo!BB's 50 Mbps ADSL service.

We beat out significant global competitors such as Lucent and Alcatel for the contract with the Chughwa Telecom in Taiwan for our NetRing optical products. China Netcom selected UTStarcom to construct its 10-gigabit backbone optical network in Zhejian Province. We won this very competitive bid over Alcatel and Fairway (ph).

In Europe, we had two key DSLAM wins in the quarter. We beat out Alcatel and Fairway for the contract with the Internet provider, Tiscali. They will deploy our NetRing and IP-DSLAM in eight European countries. We also won an IP-DSLAM contract with Versatel for the network in the Netherlands, Belgium and Germany, with displacing their incumbent equipment vendors.

On the broadband CPE in China, we shipped more than 150,000 DSL modems in the second quarter. In India, we have now deployed more than one million lines of our AN-2000 multiservice access network. We're selling our wireline solution to every major operator in India.

We are also gaining international momentum for our wireless IP core switching and SoftSwitch solution in the second quarter, highlighting including the following. We won a contract with Vonage, the North American leader in Internet telephony, for our personal communication management systems. UTStarcom also provides the core switch network to support the 4Com American Airline in-flight mobile phone test in Dallas on July 16.

In the 3G market, our MovingMedia 8000 achieved a score of 100 percent in a WCDMA radio network performance test in China's Beijing NT (ph) net field trial. We met requirements in areas such as coverage, capacity and handover, we believe the key competitive advantage for UTStarcom in mSwitch. Our field-proven IT core technology provides the foundation for all of our broadband and wireless access platforms.

Our mSwitch provides cost and performance efficiencies, as well as the scalabilities and enhanced features such as video streaming, that are far better than traditional ATM networks. In addition, CapEx and OpEx savings provided by an IP network translated into a significantly faster ROI for the operator. This factor makes IP a very compelling solution. With more than 45 million lines of the next-generation SoftSwitch deployed throughout Asia, Africa and Latin America, UTStarcom is the worldwide leader in IP core networking. I am very pleased with the growth of our global customer space and with our consistent track record of delivering strong revenue growth and solid earnings.

However, I also recognize the risk in our aggressive growth strategy and in challenges we face. This brings me the concerns and challenges that we faced this quarter. We are very disappointed with our international revenue shortfall and its effect on the gross margin and EPS this quarter. We have the customer demand and backlog in place, but missed due to our poor execution. In response, our primary challenge is to boost our internal operation and supply chain management so we can support our international expansion in the future.

Our second key challenge is to integrate our recent acquisition into our efficient business model. Our third key challenge is to reduce costs for past handsets and DSLAM solutions in China, as we continue to see the fierce pricing competition in that market. Finally, we face the challenges that executing our rapid expansion strategy and taking share in new markets, while controlling our cost structures.

Now I will share more detail about each of those challenges and discuss our plan to address them. First, a little bit about our internal operations. Our customer relationships are solid and our technology is in demand, but it has been difficult to scale our international operation to meet that demand. Making the transition to a multibillion dollar, multiproduct and multigeographical company is not always smooth. Our international revenue in the second quarter reached an all-time record, but yet fell short of our initial projections.

While we had anticipated international revenue of 100 million, actual revenue was 71.3 million. It took us longer than expected to deliver new products to international customers and achieve final acceptance. Much of his shortfall occurred in the last two weeks of the quarter. For example, in the second quarter, we missed revenue recognition of one international contract by one day. This was due to delay of the key components and the problem clearing (ph) customs. As a result, we will recognize about 3 cents EPS in the third quarter instead of the second quarter, as originally anticipated.

Such delays have directly impacted our gross margin and earnings per share. We are focused on putting a process in place to address them and correct those issues. UTStarcom has engaged global consulting firm as essential to optimize our entire global supply chain. The firm is transforming our product life cycle management, strategic sourcing and purchasing processes. These improvements will help us to better support current growth and satisfy our high customer demand.

We believe this work will help us in two key ways. One, we will realize cost savings, taking advantage of the scale by sourcing across the product lines. Two, we will improve component material quality and availabilities.

We also recognize the challenge of integrating our recent acquisition into our operations. This integration will not happen overnight. However, we have a proven track record of successful integration with our Commworks acquisition. We've purchased the selected assets of the Commworks division of the 3Com Corporation just over a year ago for $100 million in cash. After the full year of ownership, the acquisition has contributed more than 100 million in revenue and about 66 million to gross margin. Beginning in the fourth quarter 2003, the transaction was accretive to earnings.

In addition, that position offering many other dividends. We have integrated Commworks SoftSwitch capability into our mSwitch platform. This has allowed us to adopt mSwitch quickly in international markets. This integration has also enhanced its capability and expanded its reach.

The PCMS technology is now a part of mSwitch platform. Several North American, Latin American and European carriers are now PCMS customers. This existing deployment helped us gain mSwitch penetration globally. This quarter's past contract with Telefonica del Sur in Chile is an example of the successful cross-selling of the mSwitch and PCMS.

Our PDFN (ph) and our home agent solution are now deployed within nearly every major CDMA carrier in the world. This relationship plus those we will gain from Audiovox position UTStarcom very strongly to deliver our CDMA infrastructure and handsets into those carriers. We are following this successful integration model as we integrate all new acquisitions.

During the quarter, we received regulatory approval of the acquisition of Audiovox. We expected the deal to close at the end of the third quarter or at the beginning of the fourth quarter. In addition, the Audiovox team, led by Philip Christopher, has hosted Verizon, Sprint, and Virgin Mobile at our facility in China. We are on schedule with the CDG, XEC and customer approval process in introducing three handset designs and manufactured by UTStarcom into Audiovox channels. We expect to introduce these handsets in volume in the first quarter of 2005. These acquisitions are fundamental to our expanded wireless strategy and the long-term growth of UTStarcom.

UTStarcom is building a presence in a number of highly competitive markets, including CDMA handsets and infrastructure, broadband and more. We are well positioned to capture market share in those growth markets. To pursue this growth, we will invest in R&D and (indiscernible). The following areas are where we have seen the strongest growth in market share opportunities.

One, we see an opportunity to build market share in North and South America and in Asia for our cost-effective CDMA infrastructure and high-feature, low-cost handsets. We're negotiating with the CDMA operators, such as Sprint in the U.S. and Reliance in India. For (ph) our CDMA handsets, we will leverage our R&D sourcing and the low-cost manufacturing expertise that has made us the market leader in PAS handsets in China. Combined with the revenue from Audiovox channel, about 45 percent, or 900 million, of our 2005 international revenue will come from our CDMA infrastructure and handsets.

We believe that vendors who offer the full end-to-end solution are in the best position to meet the needs of the service providers worldwide. Our mSwitch solutions position us well in one of the hottest growth areas in telecom -- multimedia streaming over the broadband networks. We will introduce media streaming product based on our mSwitch platform later this year. These solutions are increasingly important as our carrier customers move to higher broadband speeds, such as 50 Mbps service we are currently selling into Yahoo!BB in Japan.

Number three, our IT-based broadband solutions are gaining traction in South America, Europe and India. We project that those products will be contributing 25 percent to the international revenue in 2005 compared with approximately 15 percent today. India is a particularly attractive target for us. As a high-tech is becoming a primary economic driver in India, reliable broadband service is becoming a key priority. We (indiscernible) to build a strong working relationship with all the major telecom providers in India. In Q2, we recognized our first significant revenue from Reliance, 14.1 million for our multiservice access network solutions.

Lastly, in addition, we are beginning to see the initial interest by U.S. carriers in the our IP-based DSLAM solutions. We're hiring the engineering staff in the area of the CDMA, IP SoftSwitching technologies, IP-based broadband, and IP-based DSLAM. We believe the R&D investment made today will result in stronger long-term market penetrations.

In closing, I believe we have the right business and operating model to achieve our vision to become a $10 billion company by the year 2008. We believe that shareholder value is driven by dominant market position, revenue growth, and profitabilities. Through organic growth, partnerships and strategic merger and acquisition, we have expanded our technology, products and global reach and ensure our long-term success.

I am fully aware of the risks associated with our fast pace of the growth and understand that the path of our goal may not always be smooth. But our proven track record makes me very confident in the Company's ability to remain a competitive global player. I believe that UTStarcom will emerge from the challenges of this transition a larger and stronger Company that is prepared to grow and succeed well into the future. Now I would like to turn the call over to Mike.

Thank you, Hong. First, I will give detailed comments on our second-quarter financial results, and then I will give updated guidance for 2004 and 2005.

Sales for the second quarter were 689.6 million, as compared to 405.8 million in the second quarter of 2003. This is an increase of 70 percent year-over-year. The growth is primarily due to strong demand for our core PAS infrastructure solutions in China. In Q2, wireless infrastructure accounted for approximately 62 percent of sales, handsets accounted for 28 percent of sales, and 10 percent of sales came from our wireline products.

Overall, the total number of PAS subscribers in China grew to 53.9 million in Q2 2004, with more than 30 million of these subscribers on our networks. With utilization of UTStarcom PAS networks at about 70 percent, it is clear that PAS subscriber growth will continue to drive both handset and infrastructure sales.

Revenue for mainland China represented approximately 90 percent of total revenue for the quarter. As Hong discussed, we continue to be confident that non-China's revenue will come in at about 600 million for the year. However, recognition of those revenues will be lumpy from quarter-to-quarter, tied to both customer rollout schedules and timing of final acceptance.

Gross margin dollars for the second quarter were 175.5 million, compared with 137.5 million in Q2, 2003, an increase of 28 percent. Gross margin was 25.4 percent. Clearly, gross margins were disappointing this quarter, as we had initially targeted 27 to 28 percent. We had initially anticipated higher international revenues, which typically carry gross margins of 45 to 50 percent. Instead, revenue from mainland China, where margins are in the high 20s, contributed a higher percentage to our overall revenue. Also in Q2, driven by pricing pressure in China, companywide handsets margins were 18 percent, while infrastructure margins were approximately 28 percent.

As we discussed in our last conference call, we recognize the need to improve gross margins and will focus on that for the balance of the year. However, we also believe that we need to continue to focus on growing market share, revenues and net income. I will give specific margin guidance later in the call.

SG&A expenses for the second quarter were 67.8 million, or 10 percent of sales, as compared to 35 million or 9 percent of sales in Q2 of 2003. The increase is primarily related to higher payroll costs associated with expanded sales activity, as well as spending on our internal supply chain infrastructure optimization and 404 compliance. Our SG&A headcount increased by 780 employees from June of last year to June of '04.

Our R&D spending for the second quarter was 52.6 million, or 8 percent of sales, as compared to 36.1 million or 9 percent sales in Q2 of last year. We continue to increase our R&D staffing in all of our facilities, with primary expansion in both China and India. We added approximately 980 engineers between June 30 of 2003 and June 30 of the current year -- 565 in this second quarter alone.

We believe the leverage we have with our R&D capability is a key advantage. Much of the increase in Q2 staffing and expenses is directly attributable to our recent acquisitions of Hyundai Syscom and TELOS. Development dollars are being focused on 3G, WCDMA and TCDMA, broadband, DD Pont (ph) and transport in our IP-DSLAM products.

Net interest and other income and expense for the second quarter was income of 5 million, compared to expense of 1.4 million in the second quarter of 2003. The increase in net interest and other income for Q2 is primarily due to positive currency fluctuations from the year-ago quarter on yen-denominated assets and liabilities.

Our effective income tax rate for the quarter was 20 percent. Net income for the second quarter was 43.2 million, or 32 cents per share. This compares with 39.4 million, or 33 cents per share, in Q2 of 2003. Though this quarter's EPS results came in just below our initial guidance, we continue to demonstrate strong profitability as we execute our long-term growth strategy.

Now I would like to turn to the balance sheet. Our cash and short-term investment balance at June 30 was approximately 561.7 million, as compared to 766.3 million at the end of March. Uses of the cash during the quarter included the repurchase of approximately 1 million shares at an average price of $29.79 under our stock repurchase program. Total cash outflow for this was 29.4 million. In addition, we incurred costs of 44.7 million associated with the acquisitions of Hyundai Syscom and TELOS Technologies, and we spent 34.7 million for property, plants and equipment.

In the second quarter of 2004, operations consumed 91.3 million. Our accounts receivable balances increased to 539.5 million at the end of Q2 from 432.5 million at the end of Q1. There are two factors behind this increase. One, in Q2, revenue increased by 67.3 million compared to the first quarter. And secondly, the receivable cycle in China lengthened, primarily due to the anticipated China Netcom IPO.

Account receivables Days Sales Outstanding were 70 days for the second quarter, compared to 58 days for the second quarter in 2003. This figure also reflects the lengthening of the receivable cycle. We anticipate that DSOs will fluctuate from the 60s up through the 80s for the balance of 2004. Inventory at customer sites under contract that were deferred to costs/inventories was 334.9 million as compared to 426.2 million at the end of Q1.

Inventory was 435.5 million at June 30, as compared to 318.1 million at March 31. And as we stated in the second quarter of 2003 call a year ago, we are working to steadily improve inventory turns by improving final acceptance cycle times, shortening supply chain cycle times, and our inventory turns improved again this quarter to 2.7 as compared with 2.3 at the end of the first quarter, and we continue to target inventory turns above 3 by the end of the year.

On June 30, customer advances were 149.2 million compared with 302.3 million on March 31; and deferred revenue was 49.5 million, compared with 57.2 million as of March 31. As I mentioned before, we are seeing a slightly slower payment cycle from China Netcom, due to their targeted IPO in late Q3 or early Q4. The other thing that (ph) we're watching this line item is the customer (indiscernible) to shift scale with inventory customer sites throughout the year.

As Hong said earlier in the call, UTStarcom is in the process of a significant transformation. We are focused on improving our internal processes and systems as we scale our business to execute on our aggressive international expansion strategy. While we are dedicating resources that support growth and international sales, we also remain focused on the China market. We intend to capitalize on its continued tremendous growth potential.

Strong positioning in the China market and growing international demand demonstrates the strength of our strategy. Now is the time for UTStarcom to capitalize on these strengths to increase our global market share and positioning for the long-term. At the same time, in the short-term, we have experienced delays in product shipments and revenue recognition in the international markets, as well as significant pricing pressure in China. For these reasons, we are revising our 2004 and 2005 guidance as follows.

For the third quarter of 2004, we estimate revenues will be approximately 695 to 700 million, of which approximately 25 percent should come from international markets. Sequential revenue growth for Q4 should be approximately 15 percent for our core business, and then add another 200 million for the anticipated Audiovox revenues. We reiterate our full-year 2004 guidance of approximately 2.8 billion for the core business, plus an additional 200 million from Audiovox, for a total of 3 billion, an increase of approximately 50 percent over 2003.

While we do not give specific book-to-bill or backlog on a quarterly basis, I believe it is important to note that our year-to-date book-to-bill ratio is above 1. We also reiterate that approximately 600 million in 2004 revenues will come from our global markets, including Asia, Latin America, North America, Europe and Africa.

By product type, wireline systems should represent approximately 20 percent of sales. This reflects strong growth in broadband ADSL, optical, metro (ph) applications, voiceover IP gateways, Class 4 and 5 SoftSwitches and video streaming. Handsets will account for approximately 40 percent of revenues, reflecting continued strong subscriber demand throughout China, growth in PAS outside China and initial revenues from ACC in the fourth quarter. Due to continued expansion in deployments of PAS networks in China and global markets, total revenue from wireless systems will be approximately 40 percent.

With regard to gross margin guidance, we stated on the first-quarter conference call we believe Q2 was the low point for gross margins and believe we can and will improve core company gross margins in the balance of 2004. Specific margin guidance is as follows. In Q3, gross margins should improve to approximately 27 to 28 percent, and we should see further improvement in Q4 to approximately 30 percent of the core business. With the ACC revenue contribution of approximately 200 million in the fourth quarter, overall gross margins should be approximately 27 percent in Q4.

Our confidence in improved margin percentage is driven by the following factors. One, a significant ramp in international revenues in the second half of '04, which typically carry a higher gross margin in the range of 45 to 50 percent. Two, stabilization of the yen versus the dollar on cost of goods, as we discussed in Q1. Three, the gradual introduction of our internally designed ASICs that will significantly reduce handset costs and exposure to the yen, as well as stabilization in the handset pricing in China. Four, the continued stabilization of infrastructure pricing on PAS in China.

SG&A in Q3 and Q4 should increase each quarter in dollars and come in as a percentage of sales roughly 10 percent in Q3 and 8 percent in Q4, inclusive of the Audiovox acquisition. R&D in Q3 and Q4 should increase in absolute dollars and come in as a percentage of sales at approximately 8 percent in Q3 and 6 percent in Q4, inclusive of the Audiovox acquisition.

Other income and expense and equity income and loss should be income of about 1 million per quarter, and this figure reflects interest income, expense, tax refunds and potential foreign exchange and impairment charges. Joint venture and minority interest should be a loss of approximately 2 million each quarter. And our effective tax rate for 2004 should remain at about 20 percent. The EPS guidance for Q3 is approximately 34 to 35 cents, and our revised full-year 2004 GAAP EPS target is $1.65 to $1.70, inclusive of all of acquisition-related charges.

Given the current collections environment, we are taking a cautious stance with cash flow guidance. We now anticipate being in the breakeven range in cash flow from operations for the year.

Our 2005 guidance, we have an initial bottoms-up projection for 2005 based upon current discussions with customers. We anticipate approximately a 25 percent growth in both revenues and GAAP EPS on our core business. We then add another 800 million and 15 cents earnings per share for the Audiovox acquisition, bringing the totals to 4 to 4.3 billion in revenues and GAAP EPS of $2.20.

Revenues broken down by category for 2005. Wireline infrastructure should contribute approximately 20 to 25 percent of revenues; handsets should contribute approximately 40 to 45 percent of revenues; and wireless infrastructure should contribute approximately 35 to 40 percent of revenues.

I would like to close this discussion by reiterating Hong's vision of growth for UTStarcom and his commitment to executing on our growth plans. UTStarcom is in a year of significant transition. We believe we have the right pieces in place to build on our success as one of the leading global telecommunications suppliers, but that success does not come without challenges. While the company undergoes this major transformation, we continue to grow and are extremely profitable.

I hope that we have been able to lay out for you how we expect to take on these challenges and why we believe UTStarcom will achieve its long-term goals. We believe UTStarcom will exit 2004 a significantly larger, more formidable company.

Before I turn the call over to questions, I would like to take a moment to address some recent investor inquiries. One on the China economy. There have been many articles in the news lately regarding the desire of China's government to slow the economy, which we believe is the case. However, our understanding is that they will continue to grow the economy in the 8 to 9 percent rate for the next several years, with an emphasis on consumer spending, such as telecom services.

In terms of the slowdown, we see government curtailing less efficient spending in the areas that rely heavily on scarce resources, such as power and transportation. These areas include commercial real estate development and heavy industrial, such as steel and aluminum.

In terms of telecom, while we do believe 2004 CapEx levels in China will most likely end 2004 slightly below 2003 spending levels, we believe the focus of that spending, at least on the part of the (indiscernible) operators, is shifted in greater proportion to PAS and DSLAM, as those are the services which drive the majority of their revenue and profitability.

Second, inquiries on Chinese operator mergers. There has also been rumors of a proposed merger in China of China Telecom with China Unicom, and China Netcom and China Mobile. Based on our discussions with the regulatory authority, the central government and the operators, we believe this rumor is false. It is believed that the rumor evolved out of a proposal submitted to the National Asset Committee by a group of professors (ph) in China, but the government has taken no action in this regard.

More importantly, we do not believe such a transaction makes sense given China's current move in the direction of an open, market-driven economy. It essentially goes against all the work of the government has done to date to create multiple operators and encourage fair competition amongst them.

Third inquiry, PAS handset competition and pricing pressure in China and the status on the introduction of new Asics. UTStarcom continues to maintain a dominant market share of 55 to 60 percent on PAS handset market in China. We also believe that UTStarcom is one of only two to three profitable PAS handset vendors in China, and for that reason, we expect both vendor consolidation as well as vendor exodus from the market throughout the balance of 2004.

Despite that, we do continue to see pricing pressure and competition in the PAS handset market in China. To improve our competitive cost structure and our profitability, UTStarcom will begin the introduction of its own Asics and PAS handsets throughout the balance of the year with the full benefit realized in 2005 of approximately 4 to $6 per handset.

Last inquiry before we go to questions, (indiscernible) introduction of new CDMA handsets. As Hong mentioned, we continue to work to bring our own CDMA handsets to market. We plan to introduce three CDMA handsets in late Q4 or early Q1, with ASPs ranging between $99 and $169. We are on a schedule for these introductions and are entering Phase I of CDG, which is the CDMA development group testing, as well as the FCC and carrier qualifications in the U.S. and other international markets. In addition we are also working through the NII qualification process for our CDMA and GSM and dual-mode handset offerings in China.

Now I want to ask the operator, Brenda, to open the call so we can answer your questions. I would like to remind everybody to please limit your question to one so more people can participate.

(OPERATOR INSTRUCTIONS) Earl Lum of CIBC World Markets.

This is George Iwanik (ph) for Earl. Mike or Hong, could you give a sense of what the gross margin outlook is for the product segment, so for handsets, infrastructure, and the wireline activities at the end of the year? And what do you think is sustainable in the long-term?

The margin that we have been seeing particularly in handsets we will see those (technical difficulty) -- the margin that we are seeing for the handsets will continue to see very fierce competition throughout the year. And we will see -- the margin will be improved in the second part of the next year and because we will start shipping our own ASICs.

From an infrastructure point of view, we have already seen the stabilization of our margin, so in the second half of this year, we will see the improvement and continuing into the next year.

As the whole of our overall margin as a Company, our mix of our international revenue as well as our China mix will be heavily towards the international revenue side, so we see a significant improvement in our margin towards the second half of the year, and I hope that will continue into 2005.

Thank you.

Mike Ounjian with CSFB.

Great, thank you. Could we talk a little bit more about -- in terms of the international revenues that were delayed from Q2 to Q3 -- they were delayed from Q2 -- sort of how much we should expect to see in Q3 and why we wouldn't expect more of a gross margin improvement from that in the Q3 guidance?

I will go ahead and take that one. The slip was -- we don't want to go into too specifics, but it was in Japan where we saw the slip in Q2 that Hong referred to. And what we're looking at is we're looking at our international piece being in the neighborhood of 20 -- maybe as high as 25 percent of our revenues in Q3, and then continue to ramp from there in Q4 to reach 600 million at least for the total year. That's very much spread across all the markets -- Japan, we mentioned India, Latin America, North America, Europe and as well as Africa. So we are seeing customer demand across the board.

I think the next question is why we will not see any more improvement in the margin. It's because we have been still seeing some of the pressure in China market and we will have to work it out some of the lower margins in Q3, which were anticipated in China as well. So in the mix of that, we have been conservatively to put it at 27 to 28 percent margin in Q3.

Great. Thanks. And could I just clarify, the 600 million international, does that include Audiovox contribution in Q4?

No, so if you want to include Audiovox, it would actually go to 800 million for the year.

Tim Long with Banc of America Securities.

It is actually Cobb Sadler for Tim Long. I had a question on the IP-DSLAM penetration in North America. I guess there's a lot of FTTP activity, and then for copper-based products, you've got a lot of interest in video. So where do you see IP-DSLAM revenue going over the next year or so, and what do you think it could be of total IP-DSLAM revenue for North America?

North America, we're not expecting a lot of IP-DSLAM as of yet this year. We do see some of those trends. We have been talking to some of the incumbent operators aggressively. We have been actively discussing and trying to tell them the beauty about IP-based compared to the ATM. And we are finally getting a lot of attention from them. In fact, as we understand, there were a couple that are RFI and I hope in the future it will be becoming RFP, turning into market before the end of the year. So we have been starting seeing some of the trends from incumbent operators. I cannot tell you who it is, but we have been seeing -- many of them have been shifting.

Sounds great. Thanks a lot. On handset penetration in North America, could you talk a little bit about that and what you're hearing from the carriers?

Using the platform of Audiovox today, of which they are the major provider to -- Audiovox is provider to Verizon, to Sprint, and Nortel and the Bell Mobilities in Canada and Virgin, as well as many others. Ad they are one of the very few companies -- and the T-Mobiles and the Cingulars. So they are one of the very few companies, and very unique part of U.S. distribution in handsets is everybody is going through their operators. And so it's a very limited company can be participating in that. And what we can help Audiovox is to provide them more the resources and getting more of the handsets available so they have a lot more choices, and therefore, we will be able to give them a lot more advantageous position to give the supply to the customers today.

Okay, thanks.

Tienyu Sieh, analyst.

I guess I just wanted to check -- since the analysts' day, what has been some of the most specific changes in your outlook as far as margins are concerned? It appears to be concentrated on the operating expenses and the gross margin. But again, it seems to be a very sharp deterioration in terms of the last 30 odd days. Can we get a bit more color as to the (multiple speakers) trajectory of change might --.

I would be happy to take that question. I think what we saw specifically is a significant amount of dollars actually slipped out of Q2 that was international but had significant margins. So that clearly impacted our Q2 gross margins, as well as our overall level of EPS.

On the last call, if you remember, we had guided to gross margins of about 28 percent in Q3 and we said 30 percent in the fourth quarter. So what we're saying this time is 27 to 28 percent in Q3 and we're saying we will still get to 30 percent in the fourth quarter. So I think what we're seeing is the handsets specifically in China continue to be very tough. And specifically, our gross margins in Q2 were 3 percentage points approximately lower than they ran in Q1. We do think the margins will stabilize there on the handsets, but that clearly contributed, as well as the international slip in Q2. And then if you look at our guidance for Q3 and Q4, I think we're still fairly close in Q3 and staying right on target for the fourth quarter.

I just wanted to point out that we were not until the very last two weeks of the last quarter that we were fully anticipated to ship out the product. And because of -- as I have admitting that our poor execution and not being able to get the product out in time and some of the blame is because the shortage was much more severe than we have anticipated, and that had compounded. But at any rate, the business itself we feel very, very strong. We are very happy about the customers' demand, and just we did not execute it, and that is just that. So we see with Q3, we have already put the program together, so we hope that would not happen again like what happened in Q2.

The key thing is we do have the backlog, and as Hong says, it comes down to execution.

But you're becoming incrementally more conservative with regard to your ability to execute, as reflected by the lower margin expectations, right?

I think definitely some of the competitiveness in handsets, we did not anticipate it is going to be more competitive like that. And clearly, we understand some of our competitors are knowing that they are losing money there, they would still be yet participating in the market, and we did not anticipate that some of those companies would continue to sell in the markets. That is a little bit of something we have not anticipated.

But in the meantime, we have aggressively hiring our R&D capabilities, so we have not slowed down with our R&D capabilities. So we have adding our expenses, yet some of the margin has been coming down. So some of that has to be corrected, and we believe that the margin will help us in Q3, and that will bring it back actually to the normal projectory (ph) situation that we have originally anticipated.

Thanks.

Hasan Imam with Thomas Weisel Partners.

This is Ian Conn (ph) for Hasan Imam. Not to beat a dead horse, but if we could just go back to slippage in the quarter. Did I hear you say that it was worth 3 cents of EPS, and are you saying that you would have had 35 cents for the quarter without the slippage? And what would have been the impact, if you can carry it through to gross margin in the quarter and maybe even top line -- whatever you feel comfortable stating.

I think what Hong was referring to was one specific shipment that actually missed by 24 hours. And that alone would have contributed 3 cents and close to 1 percent improvement in gross margin. If you take a look at what we came in at, as we originally were targeting revenues north of 100 million for our non-China revenues for the quarter, (indiscernible) significantly higher gross margins, and most of that slipped out in the last couple weeks of the quarter. So I think we want -- to be very specific here, if we take that last shipment that we talked to, that was definitely 3 cents, up to a percent impact on gross margin.

How much is that boosting the next quarter?

I think what we're trying to do is learn from our lessons here, and so we are trying to be conservative in our overall guidance here in Q3. And so we're projecting a pretty significant ramp in international. We're having to blend that with the continued handset pricing environment. We're not forecasting our margins to improve on the handsets here in Q3, so that is hurting us a little bit relative to a quarter ago when we projected. But we don't think the handset margins will deteriorate any further, and if we execute, we should have upside those numbers.

And that 34 to 35 guidance for Q3, that kind of includes the 3 cent --?

Yes, because what we're doing is we kind of have reset (ph) for the balance of the year to achieve the 600 million.

Okay, great. Thank you.

Stephen Koffler with Wachovia Securities.

I would like to ask about the China PAS infrastructure. When you were talking on the Q1 results and during the Q2, you were consistently saying that the PAS gross margin in the first half had been low because a lot of it was on new business, where you had to price aggressively. But after that, we should get some margin relief because most of the business, I believe starting sometime in Q2, was supposed to be follow-on. Did anything change in that scenario? Did you see pricing pressure on follow-on business, and if so, why?

We actually have seen stabilization on the PAS infrastructure business this year. And the contracts we are signing, we do believe the margins are much better than we've been experiencing here in Q1 and Q2. What we're seeing really is the purging of the existing backlog through these first couple quarters, and we are projecting the PAS infrastructure margins to start flowing out much stronger here late in Q3 as we go into the fourth quarter.

Is the forward look on the gross margin on PAS infrastructure in China above or below the expectations you were thinking about one month ago and two months ago?

I would say we feel it's pretty consistent. What has happened relative to maybe a month or two months ago is the handset margins have come down a little bit from what we were thinking back in.

Thank you.

Jeff Kvaal with Lehman Brothers.

My question is about the 2005 guidance. It seems as though that your 4Q guidance is reasonably similar to what you had anticipated earlier. So could give us some sense of why you think the 2005 guidance should come in a little bit? Thanks very much.

Jeff, I think we do have input from the customers that we have built our 2005 guidance on. Clearly, it's not all in backlog. I think what we have experienced is pretty competitive pricing environment over the last quarter. And when you step back and look at what we are guiding to, we really are guiding to a 25 percent growth in our core business, both in top line and earnings. We think in that environment we have a good degree of confidence in those numbers and we think they are fairly aggressive. Let me have Hong give a couple comments.

I think that we haven't seen a lot of activities in the UMTS part of our business that we're trying to get into, particularly with I'll call it TD-CDMAs, the 3G standard. That activity we have been seeing a tremendous attraction. And we have also seen a lot of interest in the next-generation CDMA, including the one that we have recently made a demo in the American Airlines with the 4Com. And that type of solution is very much viewed by other major operators, such as Sprint and 4Com, and we anticipate that is going to come in more towards the 2005.

And the broadband as well as MSTP with our SGH optical transmission, we have been seeing a lot of active wins against the major incumbent suppliers throughout Asia, and we have been seeing some of our product in Europe as well as in North America. So if you let go of that -- and IP-DSLAM too -- we have been changing a lot of people's minds from changing over from ATM to IP, and we are the incumbent supplier to that nature of a product. And that has been actively changing, not only in Europe -- in South America, in Asia, in India. So we have a lot of activities of those. So we see a tremendous upbeat in the international revenue. That's why we're projecting the $2 billion next year.

Great. And could I ask for an update on what you think your PAS handset market share would be by the end of the year and how many PAS net adds you would expect for the year? Thanks.

The PAS cumulative market share we are still going to be at 50 to 55 and even to the 60. And to the month-to-month handset market share, we hope to be able to maintain that 50 percent. And maybe it is challenging to be at 50 percent, because there is just about too many competitors out there. Our effort and the target is to maintain at 50 percent. We do have the most attractive handset design and the cost performance, but it is hard to compete with the people who are just giving it away.

I think you asked cumulative subs at the end of the year -- I think we're still projecting 65 to 70.

Cumulative would be at 65 to 70.

Thanks very much.

Dylan Tinker, private investor.

This is Dylan Tinker at UBS. I was wondering if you could again go into the PAS handsets. For the last at least three quarters, could you gave ASPs and gross margins? And also what rate (ph) you think these will be at the end of this year.

The ASP I think is anywhere between 50 to 65s in a range, and I think it's coming towards for the 50 range. And the gross margin has been fairly competitive. I think it is in the -- it used to be low 20s. Now it's the high 10s of the margin that we are experiencing right now.

Okay, and for the year-end gross margin, again a continuation of the (multiple speakers)?

I hope we will be able to come up with a handset design that is very attractive, so we hope we will be the choice of the product instead of just dumping the product out. And our target is hopefully we will be able to maintain above 20 percent before the end of the year.

Thank you.

William Bean with Deutsche Bank.

I missed the Q2 revenue breakdown. Could you give me that again?

Real quick -- Q2 revenue broke down to wireline was about 10 percent of business; the wireless infrastructure was about 62 percent; and handsets were about 28 percent.

Okay, great. And just in terms of the numbers of handsets shipped and booked, did you give that out this quarter?

I think we are saying that our shipment was around 4 million in Q2. That is what we said.

4 million shipped, okay. And in terms of the gross margins for the going-forward Q3, Q4 and into next year, you think they will be around the 18 percent level?

What we had said is we are designing our own ASIC. And that as we speak, we're coming up with our (indiscernible) and hopefully before the end of the year, we will have our own. And that particular handset, we're not only improving our cost performance, but improving our features and functionalities tremendously, and that will be saving us 4 to $6 -- that is going to be significant in the future. So we're hoping that a sample will be out and successfully, and next year we will be able to position ourselves in a much stronger position, if you can imagine 4 to $6 savings that we will be able to achieve. And therefore, we will see handsets will be still challenging and next year we hope will be able to at the high point.

In terms of your ability to sell your handsets, what differentiates you from the guys that are giving them away, aside from the (multiple speakers)?

Well, I think the giving away -- they are going to lose the money. I don't think they can continue to do too long. And I don't think any business will be able to just give away. They may be able to do that for a short period of time. So we are hoping that they will come to the realization that you're (ph) trying to lose money, and I am sure the normal economic will not permit them to do that. That's what we're hoping for.

And we are coming up with a very attractive design, a very, very high sensitivity. In other words, our DV (ph) gain (ph) will be much higher than other products are using, other company's chip sets, so that is going to enhance tremendous of the capability of the handsets, too.

Last thing, if I may, could you talk a little bit about your expectations for the IP wireless, the TD-CDMA? Any change to guidance there and any developments that you can talk about?

I said we're extremely excited and we have been getting more attraction than we can actually handle. We have a lot of attention from South America to the continent of Europe and Africa and everywhere. We have been seeing more attraction in the European continent.

Are you still looking for around 200 million next year?

We would disappointed if we don't do that.

Great, thanks.

Reggie King with WR Hambrecht.

Thank you. First, Mike, I was hoping that you could help me with the inventory breakdown that you predicted for this quarter. The inventories at customer sites under contract seems to have gone down a little bit from last quarter. Is that related to the slippage that you saw in the international shipments that may slip into next quarter?

No, the inventories at customer sites is primarily associated with our China PAS infrastructure. And we specifically -- ever since June of last year, we have targeted to shorten the final acceptance second cycle as well as our supply chain cycle times. And if you remember, back then, our inventory turns were running just a little over one and we said we specifically wanted to get to two by the end of the year and we were going to target to get to three by the end of this current year. And so we have shown steadily improvement every quarter, and we anticipate that we'll continue to bring our turns up and we want to bring our inventory levels down.

Related to that, Mike, the inventory at factories is up, so I imagine that those two are related to each other. Is that correct? (multiple speakers)

It gets a little complicated with mix, because you've got your -- in the factory, it's a combination of wireline products as well as past infrastructure that's not been deployed and a lot of our handsets as well, because the handsets is more of a book and ship, turns-type business that doesn't have to go through a final acceptance.

And then secondly, just on the core handset margins for this quarter, if I heard you right, it sounded like they were approximately 18 percent. Is that correct?

Yes, the handset margins came in about 18 percent. Again, the reference point for Q1 was 20, 21 percent for the handsets.

Was there some externality that affected that for this quarter other than just the pricing environment that you're seeing in China right now?

No, it is -- it's continued to be a competitive environment with price pressures, ASPs did come down, and so the margins came in at 18 percent. We do see some stabilization, even though it's continuing to be competitive, so we think we can hold the 18 percent margins through the year. And as Hong's already talked about, as the ASICs come online, just how big of an impact that could be.

We have been running over an hour and we need to try to hold the questions. We had asked everybody to hold it to one question. So we're happy to take some more questions one-on-one, but I would like to have Brenda maybe open it up for one more person to participate.

Frank Marsala of First Albany.

Just a quick question. Did you mention how many handsets were shipped in the quarter and what your average selling price might have been in the quarter?

I think Hong said it was approximately 4 million handsets in the quarter, and I think our ASPs were just under $60 for the current quarter.

Thanks very much.

Again, this concludes our call. We thank you all for participating.

Thank you. This concludes today's UTStarcom second-quarter 2004 earnings conference call. You may now disconnect.