Markets & Finance

UTStarcom Goes Where the Growth Is


By Ari Bensinger Headquartered in Alameda, California, UTStarcom (UTSI) provides communications equipment for telecomminication service providers that operate wireless and wireline networks. The company's most significant success has been in China, where it has gathered more than four million wireless and three million wireline subscribers.

Driven by robust domestic economic growth, pent-up consumer demand, and the Chinese government's commitment to an advanced infrastructure, Standard & Poor's expects China's communication market to exhibit extremely strong growth over the next several years. UTStarcom, with a leading 60% market share in China's $500 million fixed mobility market, is clearly the leading beneficiary.

Standard & Poor's recently initiated coverage of the stock with its highest investment ranking of 5

STARS (buy).

GOING MOBILE. The majority of the company's revenue is derived from its personal access network system, or PAS, which allows service providers to offer voice and data services over fixed wireless and city-wide wireless mobile networks. Its mobility functions are completely integrated into the access network architecture and thus require no central office switch modification or incremental mobile switching hardware.

By integrating PAS into the existing access network, service providers can take advantage of unused central office switching capacity to carry incremental wireless traffic loads. PAS enables the creation of networks that give telecom providers in emerging markets the reliability and scalability of wireline services, yet provide consumers with the convenience and mobility of wireless service. With approximately 3.0 million lines installed in 90 cities, UTStarcom believes PAS is the most widely deployed wireless local access system in China.

For wireline networks, the company provides a broadband-ready access system called AN-2000 that consists of both central office terminals and remote terminals linked together to form a digital access network using copper, fiber or microwave radio. Over 2.3 million lines of AN-2000 access system have been deployed in China, including deployments in the six largest regional communications markets.

The WACOS system, which began shipping in 2000, is an IP-based switching system designed to deliver multiple voice and data services using a highly distributed architecture. The initial application serves as the mobility service switch for the PAS system. Future applications will support third generation services, voice over IP gateway functions and narrowband and broadband remote access services.

UTStarcom also markets a variety of handsets manufactured by multiple Japanese vendors under the UTStarcom label. It performs local assembly of the wireless infrastructure components and handsets in China and intends to develop the capacity to manufacture its own handsets internally.

TELECOM BOOM. China has evolved into one of the world's most promising communications markets, investing roughly $20 billion annually in communication technologies. Given its impending acceptance into the World Trade Organization and the Beijing Olympics in 2008, China is more determined than ever to ensure that its telecommunication infrastructure is in place to compete in the global marketplace. China's demand for communication services is highlighted by its low teledensity rate, which is a measure of number of lines per hundred of people, of about 24%. Conversely, the teledensity of more developed countries are much higher: 39% in Europe and 67% in the United States.

As recently as 1992, China claimed only 10 million telephone users. By 1998, that number had grown ten-fold to 100 million only to double to more than 200 million in 2000, according to government statistics. With a population of 1.3 billion, less than 20% of the country population has access to telecommunications. By 2005 the government expects the population of telephone users to increase to 600 million.

China's ability to invest heavily in its communication infrastructure is fueled by the country's strong economic activity. The Economist Intelligence Unit estimates that China's GDP will grow at a compound annual rate of 7.9% through 2002. Over the past nine years, UTStarcom has built an expansive network of access lines, establishing relationships at all levels of China's telecommunications industry. UTStarcom is best positioned to benefit from China's robust telecom growth.

Looking forward to 2002, we expect revenue to rise over 30%, reflecting strong demand for the company's wireless and wireline access products. An improving geographical mix of international products, coupled with higher handset margins should help gross margins widen about 100 basis points to 38%. We project operating margins at an impressive 17%. Overall, we forecast earnings per share of $0.91 in fiscal 2002, up 36% from our fiscal 2001 estimate of $0.67. We believe our earnings estimates could see significant upward revisions, as the company increases its exposure outside China.

UNDERVALUED. Given our assumption that China's communications market will continue to show strong growth for the next several years, we believe a three year annual EPS growth rate of 30% is achievable. With the shares currently trading at a price to earnings multiple of approximately 24 times our 2002 EPS, and a related p-e to growth (PEG) ratio of 0.8, well under the peer group average, the stock appears undervalued.

Assuming a conservative PEG of one, the shares should be priced at the $27 level, which would represent a 22% increase from the current price. Based on a weighted average cost of capital of 12.4% and high but decelerating growth in free cash flow generation, Standard & Poor's discounted cash flow model implies an intrinsic value of $27 to $30 a share.

The balance sheet is solid, with a low debt to equity of 10% and a strong current ratio of three. In light of its attractive end-market opportunity, upside earnings potential and relatively low valuation, we believe the shares are likely to appreciate to our market price target of $27. Bensinger is a technology analyst for Standard & Poor's


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