Long Shot: Shooting for the Stars

 | Jan 11, 2013 | 11:30 AM EST  | Comments
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Real Money's Long Shot column is dedicated to trading ideas that are highly risky, but which present an opportunity for significant payoff if they work. Such ideas are sometimes characterized as "lottery tickets" and are for only the most risk-tolerant investors, as the potential for 100% loss is high.

Hope springs eternal, so as we enter 2013, do we dare pick through the detritus of the China stock bust? Do we dare take some risk and look among the dozens and dozens of worthless frauds for the one or two China stocks that are actually honest, real companies? Animal spirits are stirring, so let's take a shot!

One of my best stock picks of all time was a discount PC company that was trading at a fraction of the cash on its balance sheet. I had originally played its IPO in 2000, then sold it and forgot about it until the summer of 2001, when I was flipping through charts, saw theirs and wondered what had happened to it. (The company was E-Machines.) The stock had a $25 million market cap, but it had $150 million of cash. It had been losing money, but a new management team installed earlier that year was in the process of turning it around. I ended up making 6x my investment in six months when the company was bought in a tender offer from a director.

The lesson: When a group is completely washed out, hated, unloved, reviled -- and you can find a real company within it that is trading below cash -- there may be an opportunity.

So yesterday, I was flipping through charts and stumbled on UTStarcom (UTSI), and my value antennas immediately went up. The company was a one-time networking stock darling, until the one-two punch of the tech bubble burst and the China fraud wave felled it. Once valued at over $4 billion in 2004, the company now trades hands at a lowly $155 million cap. The decline was deserved: In 2005, the company booked nearly $3 billion revenue, whereas it only brought in $321 million in 2011. The name is so hated that no analysts follow it anymore.

Things get interesting when we peek at the balance sheet. In the most recently reported quarter (September 2012) UTSI had $213 million of cash and no debt. All liabilities are $279 million, against $407 million of current assets, which of course includes the cash. Stocks usually trade below cash when they are burning cash, and the market is anticipating that shareholders will never recover that cash on the balance sheet. UTSI is no exception, but the cash burn is minimal. In the third quarter, operating cash flow was a negative $7.4 million.

So the key to making money on this play is for UTSI to return to at least cash flow break-even status. (And this is all contingent on the numbers being for real and not a fraud. More on that later.) Only time will tell, but the company is aggressively restructuring to return to growth. Coincident with the last earnings report in November, UTSI announced an aggressive restructuring and new strategic plan. The plan is being driven by its newly appointed CEO, with the support of new directors and a new CFO. UTStarcom had traditionally been a networking devices company selling to cable companies. The new product direction is to expand the video-over-IP products to address the growing trend of "cord cutting," whereby consumers watch video over the Internet, a la Netflix rather, than on traditional cable channels. UTSI sells its equipment mainly in the China market, but will attempt to expand into other markets.

I don't have a strong opinion on whether the new strategy will ignite growth. All I care about now is that the company stops burning cash. Any initiative that takes it to cash flow break-even will cause the stock to trade at least to cash -- actually, probably above cash as the market impounds some going concern value. My near-term target price is $1.43, a 32% gain, which is calculated as the likely per-share cash balance as of Dec. 31. If the company can return to profitability, there will be some business value that could take the stock to $2, a 100% gain from today's price.

As I mentioned above, one caveat is that it is a Chinese company, so we really don't know if we can trust the numbers. I am inclined to make the bet, because UTStarcom has been public for years, and because it is a tech company. Most of the country's frauds were relatively recent and I am more inclined to trust a technology company's   numbers because their customers look at their financials. Any taint to the numbers would destroy their business. So we cannot be sure, but I am guessing the numbers are real.

The next catalyst should be in February or March when the comapny reports earnings. If its cash burn is minimized and the company can give 2013 guidance that looks for cash flow to break even, the stock could shoot for the stars. Management clearly believes in the turnaround -- or at least in the value I see here. They recently repurchased $30 million of stock in a tender offer at $1.20 per share. No management or directors sold stock – rather, this action returned some capital to shareholders willing to sell too cheap. This move is shareholder friendly, and a coming reverse split will also make the stock more "buyable" for institutions.

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