When I see companies that repurchase large amounts of their own stock my curiosity is usually piqued. It’s even more interesting when it’s a Chinese company with a large cash balance because in this case the share buybacks are killing three birds with one stone. It not only shows that management is willing to return cash to shareholders and is capable of sensible capital allocation, it’s also proof that at least part of the cash balance is real. Before continuing the discussion, some quick stats on the company in question, UTStarcom:

Last price (Feb 8, 2013): $0.98
Shares outstanding (Jan 10, 2013): 117,068,276
Market Cap: $114.7M
P/B^*: 0.57x
P/NCAV^*: 1.11x
Cash/share^*: $1.56
* Based on quarter ending 30 September 2012, adjusted for tender offer completed 10 Januari 2013

Share repurchases

UTStarcom, that aims to become “a next generation media company”, has been repurchasing shares on the open market since Augustus 2011, and the last time they provided an update on the share repurchase program the company had bought back approximately $14.2 million worth of shares. At the time this represented roughly 10% of the outstanding shares. Not too bad, but apparently this was not going fast enough since at the end of November the company launched a tender offer to repurchase $30 million worth of stock at $1.20/share, reducing the share count with another 17.4%.

The tender offer was completed early January, and what is perhaps most interesting is that just 63.4M shares were tendered in the offer. That was at the time just 44% of all outstanding shares while the tender offer was made at a substantial premium to the price a day before the offer was made (52%), or the average trading price of the past several months (~20%). I think there are two possible explanations for this, and both are favorable. The obvious explanation is of course that multiple large shareholders think the value of the company is well in excess of $1.20/share. If they are right you have a real bargain at today’s prices. The other explanation is that a large part of the shareholder base is simply stupid. This doesn’t have to imply that the company is currently cheap, but it would mean that there is a high probability that the share price does not reflect intrinsic value.

The directors and executive officers of the company did not participate in the tender offer, but since insider ownership is quite low I don’t think this tells a whole lot. More interesting is that their biggest shareholder (Shah Capital Management) did not sell shares in the tender offer, and actually increased their position. They now own 17.7% of the stock, and their latest form SC 13D/A contains an interesting note:

Recently, reporting person proposed the following action to the issuer:

– encourage management to monetize over a billion dollar carryforward losses by selling related subsidiaries in the US

So this is not only a nice hint where we should look to find some ‘hidden’ value, it also shows that the biggest shareholder is actively working in trying to unlock this value. Looking at some older SC 13D/A filings from Shah Capital it seems that management does listen. In July they proposed not only the above, but a few more value enhancing actions:

Recently, reporting person proposed the following action to the issuer:

– make a tender offer to buy back extremely undervalued shares
– encourage management to monetize over a billion dollar carryforward losses by selling related subsidiaries
– announce a special dividend in light of over $285 million cash held by the company

There hasn’t been a dividend, but spending $30 million in a tender offer to repurchase stock seems like a pretty good use of capital. I also think that their regular stock buyback program is still active. When the tender offer was launched the company had 143.7M shares outstanding, and after the tender offer just 117.1M. That’s 1.6M shares less than what you would expect based on the 25M shares repurchased in the tender offer. They have been keeping this quiet: previously UTSI provided a monthly update on the share repurchases.

Small note about Shah Capital: UTSI seems to be a pretty significant holding for them. Their stake is worth ~$21M while they had $275M AUM at the end of 2011. They also have a small long position in Suntech Power (STP). I’m short…

Balance sheet

The next piece of the puzzle is the balance sheet. As is visible below the company does have a lot of cash of cash on the balance sheet. The balance needs to be adjusted downwards by $30 million since this money was spend in the tender offer, but even after this adjustment there is $1.56/share in cash while there is no debt.

UTStarcom Holdings Corp.
Unaudited Condensed Consolidated Balance Sheets
		September 30,		December 31,
		2012		2011
ASSETS		(In thousands, except par value)
Current assets:
Cash, cash equivalents and short-term investments		$                    213,091		$                    303,998
Accounts and notes receivable, net		12,348		20,216
Inventories and deferred costs		129,005		137,484
Prepaids and other current assets		52,888		42,099
Total current assets		407,332		503,797
Long-term assets:
Property, plant and equipment, net		10,580		12,199
Goodwill		–		13,820
Intangible assets, net		–		3,625
Long-term deferred costs		24,951		39,741
Other long-term assets		63,072		27,758
Total assets		$                    505,935		$                    600,940
LIABILITIES AND EQUITY
Current liabilities:
Accounts payable		$                      22,836		$                      23,530
Customer advances		84,763		82,589
Deferred revenue		44,145		64,989
Other current liabilities		40,073		52,679
Total current liabilities		191,817		223,787
Long-term liabilities:
Long-term deferred revenue and other liabilities		87,474		106,114
Total liabilities		279,291		329,901
Total equity		226,644		271,039
Total liabilities and equity		$                    505,935		$                    600,940

There are sizable liabilities on the balance sheet though, but these are mostly related to future period revenue that hasn’t been recognized yet and the company also has offsetting assets in the form of deferred costs. I haven’t totally figured out how to value those assets and liabilities. The company has a total of $158M in inventories and deferred costs while there is $143M total in deferred revenue. I would assume that when the company recognizes the deferred revenue it will recognize at the same time the deferred costs, but I don’t know how profitable this revenue is and if the company needs to incur additional costs before the service and/or product can be delivered to the customer (and the revenue can be recognized). The same can be said about the $85M in customer advances and the $53M in prepaid assets. How much money, if any, does the company need to spend to turn the $85M in customer advances into revenue?

So while I’m not sure what the exact asset value of the business is I do think one thing is clear: the majority of cash that is on the balance sheet is excess cash that can be used to invest in new ventures or be returned to shareholders.

Tax assets

The filings of Shah Capital Management pointed me in the direction of significant off balance sheet assets. The company generated large losses in the past and it has large net operating loss carry forwards in various countries around the world. These assets have the potential to be more valuable then the company itself. We learn in note 15 of the latest 20-F filing that the company has $477 million in deferred tax assets that are offset by an almost equally large valuation allowance.

I don’t know how easy it is to monetize these assets. Shah Capital Management proposes to sell the related subsidiaries in the US, but as far as I know “a change of control transaction” invalidates the NOL carryforwards. Maybe they can be preserved if the transaction is structured sufficiently creative?

As of December 31, 2011, the Company’s U.S. federal net operating loss carryforwards were $366.7 million and expire in varying amounts between 2026 and 2032. As of December 31, 2011, state net operating loss carryforwards were $293.6 million and expire in varying amounts between 2012 and 2032. The Company has concluded that these federal and state net operating losses did not meet the more likely than not standard contained in FASB ASC 740-10 and has therefore placed a $142.8 million valuation allowance against the related deferred tax assets.

Given the fact that UTSI’s market cap is currently around $115 million I think it’s obvious how valuable the tax shield could be, if it’s indeed possible to realize the value by selling the US subsidiaries. Otherwise the company needs to generate significant profits itself, and given it’s history that could prove problematic. Buying an already profitable company is also an option, but given the size of the carryforwards it’s not going to be easy to fully use them.

Historic performance

Valuing UTSI based on it’s past results is a futile exercise, and that’s a good thing because the billion dollar in carryforward losses didn’t come out of nowhere. The company IPO’ed at the height of the dot-com bubble in March 2000, and the share price peaked that month at almost $88/share. Since then things have been going downhill, and the past 5 years the company managed to generate a $623 million loss.

Luckily the company hasn’t maintained it’s previous course, and it has restructured it’s operations significantly, starting in 2009. The company divested it’s IPTV business at the end of Augustus 2012 and simultaneously appointed a new CEO. A few months later the company unveiled a new strategic plan promising to transform itself in a higher growth and more profitable business. How successful the company is going to be remains to be seen, but at current prices you don’t need them to execute flawlessly. An average performance and profitability is already going to be great given the current starting point.

While there is a lot of uncertainty with regards to the future prospects of UTSI one thing that is good to see is that it is, after the latest divestiture, the company is not hemorrhaging cash. It could very well remain a melting ice cube though. Adjusted for the latest divested division the company had a $8.8 million operating loss for the past nine months, and the company expects to be “slightly below operating cash flow breakeven in 2012”. Adjusted operating cash flow for the past nine months is minus $5 million. Last year the company was actually profitable for the first time in a long time when it reported 21M in operating income.

The China factor

US listed Chinese companies are often cheap because investors are (rightly so) unsure if what they are buying is real. I’am not sure if this is a factor for UTSI: their historic financial performance is more than enough not to like their shares! And if you dig a little bit it’s not hard to find some other ugly things in the companies past, such as issues with their internal controls and possible violations of the Foreign Corrupt Practices Act.

While the business is ugly I’m confident that it’s real. The poor historical results itself are a good indication, and we have recently also seen that at least part of the cash is real thanks to the large share buybacks. The company also has a lot of ties to companies outside China. A large shareholder (owning 10.2% pre tender offer) and big client is for example SoftBank, a large Japanese telecommunications company with a ¥43 billion market cap. If someone would know if the company is real it’s them. The recent change of the CEO is also good news: I don’t think it’s likely he would have an incentive to continue a fraud of his predecessor.

Insiders

As already mentioned insiders own a very small part of the company, and while that’s something I don’t like to see it’s not that weird in this case since there has been a lot of turnover in the management positions. Hong Liang Lu, a cofounder of UTSI and currently a board member, is the biggest inside owner with a 2.4% stake. While the companies directors and executive officers did not participate in the tender offer it seems that Hong Liang Lu has been selling shares and reducing his stake. He owned 2.6% last July when the latest proxy statement was released.

What is good to see is that shareholders are represented on the board. BEIID owns 7.9% of the outstanding shares and has part of a stockholders rights agreement the right to appoint one director to the board. They are represented by Xiaoping Li who was elected chairman of the board after the IPTV divesture last year.

Random note: one of the directors on the board (Tianruo Pu) used to be the CFO of China Nuokang Bio-Pharmaceutical, a name that the regular readers of this blog will recognize. NKBP went private successfully last Thursday, making me some money in the process.

Conclusion

UTStarcom is a company with an ugly past and an uncertain future, but at the same time it’s really cheap. It’s trading at a 40% discount to their cash balance and the off balance sheet tax assets are potentially very valuable. The current management team has also demonstrated that they are listening to shareholders and are capable of good capital allocation by buying back a bit more than 17% of the outstanding shares in a single transaction. UTSI is not an investment without risk, but I think it’s just too cheap to pass up.

Rating: on a scale of one to five I’m going to give this idea two stars. I think UTSI is really cheap, but quite risky at the same time. This certainly could turn out to be a case of a melting ice cube, or worse!

Disclosure

I will be long when you are reading this, but not going to buy a big position.