Tekelec makes routers for telephone companies. Its core expertise is in the area of signaling protocols, which carries control information about the underlying telephone traffic, including the telephone number dialed to/from and the billing number of the call. Signaling protocol allows features such as number portability, call forwarding, voice mail, call waiting etc. Wireless phones generate more signaling traffic than wired phones, and smartphones like the iPhones generate even more signaling traffic. Some 79% of Tekelec’s revenue is derived from the wireless industry, with AT&T, Verizon and the Orange Group being its top customers, making up approximately 10% of revenue each. Being a capital infrastructure company, revenues are lumpy, with a tendency to spike in the fourth quarter as telecoms rush to use up their capital investment budget. Tekelec has a 70% market share in the US, and has market shares ranging from 40-70% in India and Latin America, with India being the second largest market outside of the US. Competitors in signaling systems include Nokia Siemens, which dominates the European market, and Huawei, which dominates the China market. About 65% of TKLC revenue is derived from outside the USA, with much of the revenue (42%) from emerging markets.
The main driver of TKLC sales in the international market is the mobile number portability (MNP) legislation which has been adopted in numerous countries. Number portability is a feature that is wildly popular among consumers, but is complex to deploy across networks of different architectures, and is considered a risky and expensive proposition by many telecom operators with an uncertain payback. The rollout of MNP in India, in particular, has been beset by numerous delays and difficulties, with rumored resistance from many telecom operators amid strong governmental pressure. The Indian government has also delayed the process by launching security investigations into signaling routers and other hardware due to fears that Huawei routers are bugged by the Chinese military, and also investigating past auctions of wireless bandwidth which appear to have been rigged in favor of some participants. This has created a general climate of uncertainty and fear, which combined with the recent recession, has made Indian telecoms wary of making more capital infrastructure investments.
Why has TKLC, with a dominant share of the signaling systems market, suffered a sharp decline in its stock price? The primary secular threat to the company is the transition to 4G network. In the US, Verizon Wireless is leading the way with the transition to Long Term Evolution (LTE). Tekelec’s signature Eagle 5 router product, responsible for 85% of the company’s revenue, is tied to 2G/3G network technology, and is suffering from erosion in the US market. In addition, the decline in revenue has been exaggerated by the recent recession, which has seen many developing countries dramatically scale back infrastructure investments. And finally, the situation in India has led to delays in expected orders, which has caused Tekelec to miss its revenue projections in February 2011, which is the proximate cause of the sharp stock decline. The combination of the problems has resulted in year-over-year declines in orders of 31%, clearly an unsustainable rate of decline for any company. I believe that investors have are under the mistaken belief that the secular decline of Eagle 5 sales have suddenly accelerated, when in fact the company has been hit by transient cyclical problems.
Several factors suggest that Tekelec’s problems are cyclical rather than secular. Firstly, the transition to LTE and other 4G technologies is expected to be slow. For example, Verizon Wireless is the leader in LTE adoption in the US, and is scheduled to complete LTE rollout to its entire coverage area by 2013. However, LTE-capable handsets appear to be lacking, and even the Apple iPhone is not scheduled to release an LTE-capable version until 2012. Meanwhile, the vast majority of phones on the market will continue to use the 3G network, which will have to be maintained and serviced with signaling routers. If we take into account other operators which have a much slower LTE rollout schedule, it is clear that phase-out of 3G networks will be slow. Analysts are predicting a minimum phase out period of 5 years, most probably 10 years, suggesting that a revenue decline rate of 8-16% is more reasonable than a 31% rate. Secondly, the geographical distribution of the decline also suggests transient factors. The 31% YOY decline reported was actually comprised of a 50% decline in the Europe and the emerging markets, whereas orders in the US was actually up by 15% in 2010. In many emerging markets, rollout of 3G network is not even complete yet, and 4G technology is non-existent. Certainly, their populations are not expected to buy expensive LTE handsets in droves any time soon. Therefore, the slowdown in their orders of signaling routers is probably related to the European financial crisis in 2010 and one-time problems in India rather than a secular decline.
Furthermore, it is important to note that LTE and other 4G technologies do not make signaling software obsolete, merely the current generation of signaling protocols. While the protocol has to be changed to adapt to the changed underlying traffic, signal routers are still required in LTE networks, and Tekelec already offers LTE compatible routers. Signaling systems is a mission critical component of modern telecommunications networks. Switching costs are enormous, the process is highly risky, and customers are extremely sticky. Tekelec has never reported the loss of a customer once it has been chosen as a vendor. The company protects its lead in signaling system by investing some 70-90M annually in research, and has more than 200 patents on file in various countries. Due to the mission critical nature of the software, a reputation for reliability is an enormous asset when competing for contracts, since any problems may not become apparent until the solution has been fully deployed. I consider it highly likely that Tekelec will continue to dominate the signaling systems market even as the telecom industry transitions to 4G technology. In a conference call, Tekelec management reports that they have just recently completed a successful LTE pilot trial in Europe, and has booked 4 LTE customers to date, including Verizon Wireless.
In addition to signaling systems, Tekelec has also spent $165M in acquiring Camiant and BlueSlice in 2010. Camiant is a leader in policy management software. Policy software allows a telco to dial back a user’s bandwidth during times of peak usage, and allow a user to exceed bandwidth caps during times of low usage. Basically, the telco can implement any policy of bandwidth usage it desires, and can even do deep packet inspection to selectively restrict certain kinds of traffic based on traffic origin or nature. Blueslice specializes in subscriber data management (SDM) software, which pulls together a user’s records across VoIP, 2G, 3G, IMS and LTE networks, which will be increasingly important as the nation’s networks fragment into different architectures. Both policy and SDM software are not heavily deployed and are considered optional in current networks, but both are expected to grow at double digit rates, accounting for $30-40M in revenues in 2011. Tekelec expected revenues of $20M from policy and SDM in 2010, and reports that revenues from Camiant and BlueSlice have already exceeded that.
In 2010, TKLC reported net income of $15M off revenues of $424M, a decline of 8% from the previous year. On a cash flow basis, due to amortization of intangibles which has no economic basis, free cash flow is actually closer to $35M. TKLC also has no debt, and has $221M in cash on hand. Currently, the stock is trading at around $8, with 68.3M shares, or a market cap of $546M. Subtracting away the cash gives a valuation due to operations of slightly below 10 times cash flow. Therefore, the market is current assigning a multiple of about 10 to a company with a dominant market position in an expanding market off its trough earnings power. It is difficult to calculate an accurate valuation for TKLC, as the company is highly operationally leveraged, with 60% gross margins, therefore any increase to revenue has enormous effects on the bottom line. However, I consider $8 a clear bottom under nearly any scenario short of a global double-dip recession. TKLC will break even at around $350M revenue, which is unlikely to be reached.
Dangers to this investment include possible market share losses to Huawei, a possibly non-economic actor that relies on provision of cheap loans by Chinese banks to gain market share. That said, Tekelec has a strong presence in many emerging markets which are already wary of Chinese market power, and have strong concerns about the security of Chinese router products. Also, it must be mentioned that the CEO of Tekelec recently resigned, and the board of directors is searching for a new CEO. Ex-CEO Plastina has put in a lackluster performance in his 5 years at Tekelec, and his departure will probably not be missed by investors, although it does inject another uncertainty into the business. And finally, this is after all a capital infrastructure company that is highly sensitive to general economic conditions, and so is not an appropriate investment if you are expecting another recession.
Disclosure : I have a long position in TKLC.
