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Comverse Technology, Inc June 6, 2002 Software / Internet Research Comverse Technology, Inc. CMVT: Incremental Restructuring Appears &097 Likely 5DWLQJ 0DUNHW3HUIRUP Marianne Wolk 646.366.4427 Investment Conclusion: Although Comverse announced numbers Malindi N. Davies 646.366.4286 loosely in line with our expectations, results have yet to show any signs of Change In... Yes/No Was Is stabilization. Weak telecom spending, coupled with a major product Rating: No MP transition across nearly all of its business lines, continues to mean Operating EPS F2003E: Yes $(0.10) $(0.28) declines in backlog, sales and earnings. With visibility to a recovery Operating EPS F2004E: Yes $0.40 $0.09 Rev F2003E: Yes $920.0 $750.2 poor, we expect the company to take rapid actions to reduce its Rev F2004E: Yes $1,065.6 $806.3 breakeven from $220MM to $190MM+/- in quarterly revenues. Trading 12-Month Price Target: No $13.00 at 0.7x CNS revenues (ex net cash of $6.85), we believe current estimate 52-Week Range (NASDAQ) $70.50-10.00 FD Shares Outstanding 187.0 MM revisions to be largely reflected in Comverse’s shares. Market Cap $1,909.3 MM Avg Daily Volume (000) 3,700 Book Value/Share 4/02 $8.64 5yr Hist. EPS Growth Rate 44% Key Points: 5yr Proj. EPS Growth Rate 15% • COMVERSE REPORTED WEAKER-THAN-EXPECTED ROA 2003E: NA REVENUES, OFFSET SOMEWHAT BY INCREMENTAL COST Dividend/Yield NONE/ NA REDUCTIONS. Comversea reported revenues of $211MM (short of FY January F2002 A F2003 E F2004 E our $220MM forecast). The loss of ($0.04) surpassed our ($0.06) Operating EPS: estimate as the company mitigated the shortfall in revenue with a $9MM 1Q $0.43 $(0.04) A $0.00 reduction in R&D ($4MM ahead of forecasts). As with last quarter, we 2Q $0.28 $(0.11) E $0.01 estimate that interest income contributed +$0.05 to the bottom line. 3Q $0.11 $(0.11) E $0.03 4Q $0.06 $(0.02) E $0.05 DSOs grew by 22 days to an all-time high of 150 as the company Year $0.86 $(0.28) $0.09 leveraged its strong balance sheet to grant favorable financing terms to P/E NM NM NM customers. We expect to monitor these levels closely. The company’s CY EPS $(0.28) $0.09 NE reserves cover 13% of its gross receivable balance. CY P/E NM NM NM Rev (MM): F2002 A F2003 E F2004 E • 1Q $365.0 $211.2 A $192.0 DECLINE IN VOICEMAIL BUSINESS, 80% of CNS, SHOWS NO 2Q $345.1 $180.5 E $197.8 SIGN OF A BOTTOM. Voice messaging revenue for the quarter was 3Q $295.0 $167.0 E $203.7 $133MM, down 45% y/y and 25% q/q. Poor economic conditions, a soft 4Q $265.1 $191.5 E $212.9 Year $1,270.2 $750.2 $806.3 market for telecom capital spending, and increased competition are CY $750.2 $806.3 NA likely to raise pricing pressure ahead. To date, Comverse has offered Mkt Cap/Rev NM 2.5x 2.4x extended payment terms rather than succumbing to major price Mkt Cap/CY Rev 2.5x 2.4x NM reductions (thus holding gross margins above 56%). However, we also (Operating EPS before one-time items. Comverse reports a see this as a product problem. In our view, growth in traditional voice tax rate of less than 15%.) mail systems is likely to remain lackluster (low single digits) even as wireless spending recovers, as demand continues to shift to open, IP- based systems. See Figure 1. • BACKLOG, NEW BUSINESS ORDERS, CONTINUE TO DEMONSTRATE COMVERSE’S DIFFICULTIES. Backlog fell by $26MM, or nearly 12%, from last quarter, suggesting order flow of $185MM, down from $189MM. We believe Comverse is seeing a freeze on prior orders (currently in backlog), slowing the implementation of Comverse solutions and the recognition of revenues. We believe such a halt to be in place at AT&T Wireless on the previously anticipated upgrade to Comverse voice mail for its GSM/GPRS base in conjunction with a move to Unified Messaging. (Please refer to our October 11, 2001, report on Comverse’s problems at AT&T Wireless.) A similar freeze may be in place at Verizon (please refer to our December 17 report forecasting slow implementations here). • WE CONTINUE TO BELIEVE COMVERSE HAS A PRODUCT AND POSITIONING PROBLEM THAT MAY NOT RECOVER IN LINE WITH WIRELESS SPENDING OR THE 1X/GPRS CYCLE. Comverse’s three largest revenue generators include: (1) voice mail, (2) SMS and (3) prepaid services. We believe these three lines account for 80%, 12%, and 7.5% of Comverse Network Systems revenues, respectively. In our view, all three major product lines are in product transition to: (1) open, IP-based voice mail (standard message format, distributed storage throughout the network on Suna, Ciscoa, etc.) and Unified Communications; (2) MMS; and (3) prepaid-post-pay integrated systems. It is easy to refer to the weak economy, delays in the deployment of GPRS/1X, or the dearth in immediate consumer and enterprise interest as the culprit for poor demand. However, we continue to raise concerns that Comverse may not see a strong recovery with an improvement in these factors. In our view, its offerings are not well positioned to take advantage of the shift to newer IP technologies. The leader in closed, proprietary voice mail (50%-60% share of wireless), Comverse has been slow to move to open its systems fully. The No. 3 player in MMS, Comverse’s deals to date in MMS suggest it has lost market share to Nokia, Ericssona and others. Lastly, we suspect weak prepaid billing sales may reflect rising competition from integrated systems offered by Amdocsb and Convergys. • STRONG CASH BALANCES CONTINUE TO PROVIDE SUPPORT LEVEL FOR STOCK PRICE. Comverse ended the quarter with net cash of $1.285B, or approximately $6.85 a share. At this level, interest income continues to bolster the bottom-line results and provides a theoretical floor for the stock price. Although a truer floor may reflect Comverse’s cash position after the de-consolidation of cash balances held by VRNTab and ULCM, leaving CNS with approximately $989MM, or approximately $5.30 per share. In any case, we expect the net cash balance to fall over the next several quarters and the Company will continue to leverage its balance sheet to provide favorable financing terms to customers, make select technology acquisitions and support negative cash flows from operations. DETAILS: WE BELIEVE COMVERSE’S PERFORMANCE WILL REMAIN HEAVILY DEPENDENT ON VOICE MESSAGING IN THE NEAR-TERM WHERE THE OUTLOOK REMAINS WEAK. • Voice messaging has represented the lion’s share of CNS’s revenue over the last few years (CY00 81%, CY01 76%), and we project it will represent an increasing portion of revenues in the near-term. • Comverse’s voice messaging business fell by 25% q/q and 45% y/y. With limited big win opportunities in this space and continued conservative spending environment for telcos, we believe that Comverse may see some pricing pressure and that this business will continue to decline. • We do not believe that the falloff here is a pure function of the telecom spending glut and we are uncertain if the GPRS/1X cycle will provide any upside relief. The network upgrade cycle would only provide a positive impact if new data services (a) attract new wireless subscribers or (b) ultimately spur converged communications storage (i.e., a single inbox for voice, email and SMS/MMS messages) AND Comverse is able to secure that business. Neither looks like a shoe-in at this time. Figure 1. Comverse Voice Mail Business Has Not Stabilized Oct01 Jan02 Apr02 Jul02E Oct02E Jan03E C01A C02E Voice 177 177 133 109 95 110 823 447 Mail Revenues Y/Y (17.0)% (23.7)% (45.4)% (51.7)% (46.3)% (37.8)% (2)% (46)% Growth Source: Company reports and Robertson Stephens estimates. MMS MOMENTUM A MAJOR WILD CARD FOR COMVERSE, THOUGH NEAR-TERM PERFORMANCE HAS BEEN WEAK. The evolution to GPRS/1X, which should be a catalyst for industry-wide MMS sales, could help Comverse’s longer-term results IF the company successfully transitions its SMS platforms to newer multimedia technologies. Though the transition to MMS is off to a slow start in 2002 (See our June 4 report and comments on weakness at Logica), most forecasts assume a rapid shift to MMS as new networks and handsets become more available starting later this year. To this end, Mobile Streams forecasts the number of the MMS messages may outpace SMS messaging by 2007 (See Figure 2). While these figures may be on the aggressive side, they demonstrate the expected shift in demanded services. Robertson Stephens, Inc. 1 Figure 2. MMS Growth Outlook Worldwide – Number of Monthly Message Sent 2002E 2007E CAGR SMS 62.4 B 40.0 B (8.5%) MMS 0.3 B 50.0 B 340.9% Total 62.7 B 90.0 B 7.5% Notes: Based on December. Source: Mobile Streams. The big question is whether Comverse (the No. 3 player in SMS) will land any of the big deals that are appearing in the market to provide these services. This transition is already underway in Europe and Asia and Comverse is yet to participate in any of the deals that we have identified (See Figure 3). Management acknowledged that increased competition from other players as well as handset makers, such as Nokia and Ericsson, are making it difficult to forecast major wins. To this end, Comverse indicated it would attempt to take part in the MMS market as a second source – not a resounding indicator of potential future revenues.
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