UTStarcom Holdings Corp (UTSI) 2006 Q4 法說會逐字稿

Good afternoon. My name is Diana, and I will be your conference operator today. At this time I would like to welcome everyone to the third and fourth quarter 2006 earnings conference call. (OPERATOR INSTRUCTIONS). Mr. Hong Lu, you may begin your conference.

Good afternoon and thank you for joining us today. I am Hong Lu, UTStarcom's Chief Executive Officer. I'm pleased to host today's call, along with Fran Barton, UTStarcom's Chief Financial Officer, and Peter Blackmore, President and Chief Operating Officer.

The agenda for today's call includes the following chief topics. One, a review of the China sales investigation. Two, financial results for the third and the fourth quarter of 2006 and expectations of the timing of the first and the second quarter 2007 filings. Number three, an update on liquidity. Number four, an overview of our restructuring plans. Finally, number 5, with our question and answers.

With that I would like to turn the call over to Fran.

Before I begin the call, I would like to remind everyone that some of the information we will discuss today constitutes forward-looking statements, and actual results could differ materially from our current expectations. So to understand the risks that could cause results to differ please refer to the risk factors identified in our latest annual report on Form 10-K, and in our quarterly reports on Form 10-Q, and current reports on Form 8-K, which are filed with the Securities and Exchange Commission.

Now before I begin the discussion of the results of our China sales investigation, let me remind you that today we will be publishing our 10-Q for the third quarter of 2006 and our 10-K annual report for 2006. Expect them to be out shortly. Shortly means today.

This is the primary reason for today's call. We plan to give more detail on operations and guidance over the course of the next two conference calls. I think you'll find today's filings very thorough in explaining all aspects of the Company's performance. I encourage you to read them for additional insight into our operating performance. It is over 250 pages long, so it may take some time, but I think you'll find it is worth the time.

Now I would like to give you a brief synopsis of the China sales investigation. Essentially the issue is this, included in our current controls process is a whistleblower hotline, which allows employees to notify management of possible control weaknesses. This is essentially what happened when an employee in China brought to our attention concerns over certain China sales processes.

After an initial internal review, the Audit Committee initiated an independent investigation using external council and forensic accountants. As a result of the investigation, a management team, with agreement from the Audit Committee, concluded that certain revenue needed to be restated for several offices in the Western region of China.

The reasons for the restatement was that some of these sales contracts had commitments for future deliverables, and therefore revenue had been recognized prematurely. The size of the total net adjustment to revenue is approximately $278 million for the periods 2000 through 2005. This revenue is being deferred into later periods, including the third and fourth quarters of 2006.

I will remind you that there is no cash impact on this restatement. Finally, the investigation team and the Audit Committee concluded that UTStarcom management had no knowledge of the practices in the Western region that caused these restatements. We are pleased to put this matter behind us now. This issue is closed.

Now I will move on to discuss our Q3 and Q4 financials for 2006. Sales were $601 million for the third quarter of 2006, and $704 million in the fourth quarter of 2006. PCD sales were approximately $329 million or approximately 55% of sales in Q3, and $422 million or 60% of total sales in Q4.

By geography, sales in China represented approximately 32% of total sales in the third quarter, and 27% of sales in the fourth quarter.

In the third quarter gross margins were approximately 12.4% of sales. Gross margin percentage increased year-over-year, but declined sequentially due to a $7 million warranty accrual in our broadband business, also a onetime inventory write-down in PCD of $29 million, and lower revenue contribution from PAS sales in China -- a mix issue.

In the fourth quarter gross margins were approximately 11.1% of sales. The sequential decline from Q3 was largely due to high contribution of PCD to the overall product mix, and a onetime loss provision of $32 million associated with a large government broadband contract in India, and finally a $3.4 million inventory write-down in PCD.

As part of the China sales restatement there was a positive impact of approximately $8 million in revenue and $3 million in gross margins for the third quarter of 2006, and approximately $3 million in revenues and zero gross margin dollars in the fourth quarter of 2006. If you do the math, I think you'll find that after adjusting for the above-mentioned items, that the gross margins would have been consistent with prior quarters.

SG&A expenses, inclusive of stock compensation, were approximately $80 million or 13% of sales in the third quarter, and $87.5 million or 12% of sales in the fourth quarter of 2006. R&D expenses were approximately $46.3 million or 7.7% of sales in the third quarter, and approximately $43.6 million or 6.1% of sales in the fourth quarter.

Net interest and other income was approximately $2.4 million in the third quarter, and approximately negative $9.5 million in the fourth quarter due to a non-cash impairment of one of our long-term investments.

Total income tax expense was $1.5 million for the third quarter. And in the fourth quarter we had an income tax benefit of $24 million, primarily due to the release of tax reserves for potential transfer pricing issues after settling a tax audit in China.

Our total net loss in the third quarter of 2006 was $43 million, or $0.36 per share. In the fourth quarter our net loss was $42 million, or $0.35 per share.

Now transitioning to the balance sheet. Our cash and short-term investments totaled $617 million at September 30, 2006, and $671 million at December 31, 2006. This was an increase of $12 million for the full year 2006.

Our accounts receivable balance was approximately $429 million for the Q3 and $406 million for Q4, resulting in an overall decline of $117 million for the full year 2006.

Our DSO was 64 days in the third quarter and 52 days in the fourth quarter. This compares to DSO of 69 days in the second quarter -- our last published financials -- the second quarter of 2006. Our improved DSO was the result of continued collection efforts across the Company, and a mix shift to a higher portion of our revenue from PCD, which has lower average DSO than the other businesses.

Our inventory level was approximately $673 million at September 30, and $636 million at December 31, 2006. During the third quarter our cash flow from operations was negative $61 million dollars. During the fourth quarter flow from operations was a positive $48 million. For the full year 2006 cash flow from operations was positive $66 million, reflecting continued focus on working capital management, which more than offset the operating losses.

Our total short-term debt balance was approximately $105 million at September 30, 2006 and $103 million at December 31, 2006. This was a reduction of about $96 million in short-term debt over the full year 2006. Our long-term debt, which represents a convertible bond due in March 2008, continued at $275 million at both Q3 and Q4 of 2006.

Before I turn the call over to Peter to discuss our restructuring plans, I would like to give a quick update on liquidity. As discussed in our conference call a few weeks ago, we continued to carefully monitor our liquidity situation. The primary reason change since that call is that we recently made a transfer of funds out of China totaling $150 million. We also still have two equity investments with a current market value totaling over $100 million that may provide additional liquidity if needed.

So in summation of the financial action, we ended 2006 with over $2.4 billion in revenue and with a net loss of $117 million. Despite that loss we were able to generate a positive operating cash flow of $66 million, and to increase our overall cash by $12 million, all of this after paying off $96 million in short-term debt throughout the year.

As we move forward over the next several weeks we will be reporting Q1 and Q2 2007 earnings. And in early November we plan to report Q3 2007. At that time we will share with you more of our thoughts on 2008 and how we plan to return to profitable growth.

With that, I would like to turn the call over to Peter to discuss our restructuring plans.

Hello everybody. As you know during our conference call on September 17, we put forward a new corporate strategy which is aimed it focusing our efforts and our resources on select IP communication markets where we can create solutions that will drive sustainable and profitable revenue growth for the Corporation. As part of that new strategy, we have set clear goals for the internal organization that improve gross margins, manage our operating cost and improve cash flows.

As part of these goals we have put together a restructuring plan with an initial phase which will include headcount reductions of approximately 700 employees, or 11% of our workforce. The workforce reduction will be primarily in the United States and in China.

We expect to complete our headcount reductions by the end of this quarter, and as such we expect to take a restructuring charge of approximately $10 million in the quarter. And as result of headcount reductions, we expect to realize annual cost savings of approximately $21 million on an annual basis. This headcount reduction is part of our overall targeted reduction of $10 million to $15 million per quarter that we referred to in our previous conference call on September 17.

Also in our last conference call we did discuss our new corporate strategy. I want you to know that the implementation of the strategy is proceeding well, and we plan to discuss this, and to provide more detail, on our go forward business model when we report the third quarter earnings in November.

At this point, I would like to turn the call over back to Fran.

I think we're now ready for question and answers. And I would also let everybody know that our 10-Q for Q3 of 2006 and our 10-K are now filed, and they are at your -- you have the opportunity to review them through EDGAR or other processes. Let's take our first question.

(OPERATOR INSTRUCTIONS). [Andrew Rosenberg].

Fran, is there any way we can break down the rest of the revenue for Q3 and Q4 between core and PAS?

Yes. I shouldn't say this, but it is in the segment reporting we do on our K and Q that we just published but --.

It is within the filings?

Yes, it is all in the filings. We have a segment report that sort of goes through that detail.

Those will all be out there?

They are out there now. This was just published in the last 10 minutes or 15 minutes.

I must admit that I looked before the call and I --.

No, I apologize. They literally were supposed to be approximately simultaneously, but we get on five minutes before they get out.

That's fine. I will look at those here shortly. Now with regards to liquidity, you mentioned you pulled $150 million out of China. How much more do you have in China right now?

Well we have about -- a little of excess of $300 million in China right now. Obviously some of that needs to stay there, but some of that is also available to us.

And you can pull that out on a short-term basis too within --?

Yes.

Then one quick question on the cost-cutting measures, the 700 job cuts. I'm assuming that some of the rest of the targeted $10 million to $15 million a quarter there is going to be efficiency gains, but is there maybe more headcount reductions coming?

We believe that this first wave was the primary wave on the headcount portion. A large part of the additional savings, which we will be talking to you about over the next several conference calls, will deal with other things like consultants and other efficiencies inside the Company. But that is intended to be the primary headcount segment.

It is Peter here. Any other headcount savings will be minor. So there may be some minor tidying up, but that will be about it.

Peter, you mentioned too on the last call you talked about some meaningful gross margin improvements. I'm assuming you meant within the core segment of the business. Is that fair to say?

That's correct, yes.

Is there any way to look -- I guess on -- handsets seem to be a pretty nice percentage of revenues. Is there anything there from a gross margin standpoint that might be available to improve?

Yes, I think we have mentioned several times that our own UTStarcom manufactured handsets have better -- they are growing into getting right now better gross margins than the average we've experienced over the last two years. So as we look into the rest of this year and 2008, I think you will continue to see the margins in those handsets increase. And we've pretty much been holding our margins in our PAS handsets, but I would not expect any increases there, more likely even a decline as we tend to use channels more often than direct sales.

For the third and fourth quarters you just reported here, is the margin on those probably mid single digits? Would it be correct in saying that?

For the TCB handsets, yes.

But the overall PCD handsets is going to be single digits, but UTStarcom's product is higher and we are closer to the double digits.

Is there a target for that in the low double-digit?

It depends on the product mix. And some of the product had already exceeding 20%. But as a mix our target is going to be in the mid 10s -- our future trend.

One last question. What does the backlog look like today, if you can mention that?

We're not going to be too -- if you will bear with us a little bit, we're trying to clear up Q3 and Q4 of last year. And as I said, in a couple of weeks we are going to do Q1 and 2. Get that caught up. And in early November we will be doing our Q3.

So when we do our Q3, which is whatever it turns said to be, early November, several weeks from now, we will take you through all of the traditional backlog and margins, and all of the stuff you like to do. We had hoped that you could bear with us a little bit as we break this work into chunks, getting rid of Q3 and Q4 of last year, and we will go through a lot of the operational stuff shortly with you.

Thanks very much. I appreciate you guys taking the time. And congratulations on the filings, although I will wait for the third quarter as it comes out.

Mike Ounjian.

I don't know if needs to wait for one of the upcoming calls, but this summer you were kind enough to give us some indications of what bookings looked like through the first half of the year, and kind of where the cash balance stood at middle of the year. Is there any update we could get through Q3 on either of those fronts?

As I said, if you would bear with us, I would like to do that certainly no later than the November call, but we will see what we can do also for the call when we do Q1 and Q2. We're just sort of closing those books. We will try to get that to you absolutely as soon as possible.

I know you mentioned the revenue breakout for the second half of '06 is in the filings. Obviously I have not had a chance to take a look. Is there also a margin breakout down within those filings as well that we can take a look at? Or if not, is there some sense we can get of those?

Sure, sure. The answer is yes there is margin breakouts. And I think if you have the patience, and you have been extremely patient with us, I appreciate that, for the last year. To read through the -- I think it is almost a 260 page very, very thorough document. Some people have commented that we've got just about anything you would want to ask in there. And if you have the time to read it and go through it, it is a very, very full disclosure of all of our businesses, all of our onetime events, all of our investigations. Just anything you can imagine to ask about, it is in there, and it couldn't possibly be summarized well in a quick call like this.

Okay. Well I appreciate it. It sounds like we have a lot of reading to do tonight. Thank you very much.

Larry Harris.

I'm starting to read the 10-K, and I'm looking at page 5. And it is a table that shows the accumulative amount of the China sales restatement, roughly $270.8 million, and net income of $96.7 million. Will those amounts be recognized in the second half of 2006, 2007? When will we see those revenues in earnings?

So a very good question, and I apologize for mentioning the margin impact on the revenue also. What has happened is by and large these contracts will be prorated over time. So these are going to roll out over many years actually.

That $270 million of revenue well wind itself out over the next five or six or even -- parts of it will go as much as nine more years, or eight more years I guess it is. So they will -- I think something on the order of roughly $8 million of revenue per quarter for as long as I'm here. And then beyond of which the margin might be around say $3 million. So we will highlight this for a while, a quarter or two, and then we will kind of have every -- hopefully once that is absorbed by the market, we will stop making a special story about it. But it will be over -- normally it will be over quite a period of time under our current accounting.

In terms of the PAS business in China, as best I am able to determine there has been a fairly material slowdown over the last few months in terms of subscriber signup. Do you believe that with the reduction in force that you have announced today that you will be able to keep that business profitable?

This is Hong. And if we are really looking at just the PAS business, our business has been only focused on that business. Yes, we are profitable. Nevertheless, we're still going to continue to invest in the future, including our IPTV and core networks and our optical transport product. And those are the areas that we have been really focusing in the future. And we have very positive movement in some of our activities, not only in China, but throughout the other parts of the world. So we are, if only looking at the PAS things we are actually absolutely profitable. And we also have been able to maintain a relatively high marketshare too.

Even with what appears to be a slowdown in terms of new subscribers, do you think you can keep that business profitable?

Yes, yes. Absolutely.

Then finally just to clarify a comment that was made on the last conference call regarding the Personal Communications division. That is right now considered non-core?

That's correct. It is important, as we stress, because it does have a good market position in the United States, but we have made it a non-core business.

I just wanted to add, Larry, what we identify as the core business is our competitive edge and our strength compared to other companies and the future growth included. And we have a significant advantage. We have identified that our core business is in our IPTV [core] network, optical transport, broadband access type of the products are very uniquely positioned. And we really think in the future the broadband will be taking off, not only in China, but in many parts of the region and the world.

Evan Erlanson.

A couple of questions.

Can you speak up a bit please?

Evan, I think you need to get near your mike.

Okay, can you hear me now?

That's a little better.

I had some questions on the headcount reduction. Was this primarily in the area of R&D or production?

It was a combination of supply chain, some R&D, some soft functions. So what we did, if you remember the previous call, we said we would look at the business model of each business and size the business to be breakeven to profitable next year. So we did it business by business. And then we also went to the support functions. We benchmarked against best in class in our industry, and given the support functions the task of getting to the best in class model in 2008. So it was done by business rather than just a straightforward percentage cut.

On the write-down that was recognized in India on the broadband contracts, would you mind giving us a little bit more detail on maybe the customer here? And since you have announced more broadband contracts in India since then, how is that business actually going in terms of profitability?

We had just mentioned it during our conference call that we had booked a loss of $32 million in one of the very large broadband business. And this is -- our strategy to making sure that we are playing very aggressively in a very fast-growing market. We see the India market has been growing extremely fast. At least at this time that we see that is the fastest-growing -- one of the fastest-growing areas in the world.

We are positioned very well. We were awarded with the best supplier, and we also believe that we have the largest marketshare today. With future growth we have plans to getting those -- our investment back. So at least at this time that we have loss generation, but we are very hopeful that we will be repositioning ourselves to gain, not only the profit, but also maintain our marketshare.

The other contracts in India which we have made subsequent to that have all been profitable.

In terms of the broadband business overall, I don't know if you're ready to give any guidance, but for 2008 where do you think the revenue number goes for broadband, or maybe you want to give it in terms of percentage of revenue or growth?

If we may, we would like to go into that detail when we have the November call. We will be very well-prepared by then and be able to give, not only that, but a lot of other business model information for you.

Okay. And I think that there -- final question -- there has been some developments on some of your investments. I believe [Ceylon], the handset design house, has gone bankrupt. Do you think that in the first half of 2007, or perhaps the Q3 period, you will be recognizing any investment write-downs related to that or perhaps other investments?

Yes, a good point. One of the let's call it onetime events we had that I referenced earlier, we had a total of about a little over $16 million of write-off -- or write-down asset impairment in the Q4 of 2006. So in these financials we wrote that down to zero. So there is no risk ongoing. It is all valued at zero right now.

So that would be included in that number?

That is included in the numbers we gave today. And there is a write-up and mention of it also in our 10-K documentation.

This concludes the Q&A portion of today's conference. Do you have any closing remarks?

Okay, I think just again thanking everybody for their patience, we really did intend this to be a bit focused with a few updates. But the going forward updates are coming shortly as we're cleaning up our backlog. We would hope to somewhere in this month get out the next few weeks -- there's only a few weeks left in this month -- to get out with Q1 and Q2 2007 financials, which will bring us current.

And following that right away in early November 2 to stay current with our Q3 2007 financials. And as both Peter and Hong indicated, we will be shortly jumping out to a more forward-looking, and put the past behind us, and try to -- as we return the Company to growth and profitability to share with you some of our thoughts around that.

So thank you very much for today. If anybody needs any help, call -- after you have read the 260 page document, give us a call and we will be happy to walk you through it. Okay? Thank you very much. Bye now.

Thank you for participating in today's third and fourth quarter 2006 earnings conference call. This concludes today's conference. You may disconnect at this time.