Summary

TKLC is considered one of the leading global providers of communication network software and systems that enables wireless and line based service providers to deliver voice, text messaging, and mobile data services. Tekelec products help telecoms to optimize their network efficiency, increase revenue and assist in the transition from traditional networks to Internet Protocol ("IP") -based mobile networks. There are more than 1,800 Tekelec systems and software applications deployed in networks located in 107 countries worldwide.

Tekelec products and services (or similar) are considered essential to the operations of most wireless and line service providers. 

Since mid-April 2010 the company's share price has decreased over 44%, where we think it represents a compelling investment opportunity.

Before proceeding we should disclose that we are not experts in the technology or industry. Our research has focused on developing a framework to understand how Tekelec's business is run within the industry. 

Background to Investment

Tekelec's value has been significantly reduced due to a couple of earnings misses, corresponding profit warnings and a delayed order.  The stock has been virtually abandoned by analysts and traders leaving a great investment for those with a time frame longer than one quarter.

The earnings misses and delayed orders are closely related.  Tekelec has won a series of contracts in India which were supposed to start generating orders in Q1 2010 but were still caught up in Indian bureaucracy by Q3 2010.  Additionally overall economic issues have impacted orders from EM and Middle East customers.  The company expects the India issue to be resolved by end September and has seen a pick up ROW orders as credit eases. 

Tekelec is in an industry at an inflection point.  Older technologies are starting to be replaced by newer ones but timing is an issue especially during a recession when cap ex spending is scarce.  The company provides essential software and systems to three areas of the line and wireless providers.  All three areas are considered smaller markets operating outside of the large equipment providers.  In our opinion, an investment in Tekelec needs to believe that wireless voice, text and data will continue to be the most dominant forms of communications.  Given the latest industry trends, this is not a stretch.

There have been some concerns in the past that new generation technologies will severely impact Tekelec's business.  To put this into context, yes next generation technology is coming but the earliest the most advanced servicer (Verizon) is expecting full LTE (4G) conversion is 10yrs, the next (AT&T) is almost 3yrs behind Verizon with the majority still trying to get to 3G.  We accept that technology moves very quickly, but infrastructure takes time and money.  With billions already invested to catch up to existing technology, wireless operators have opening stated they are in no hurry to move.  Remember also, that Tekelec has products for the next generation.

The three areas of Tekelec revenue generation are:

1)      Signaling systems and software:  an essential service that allows service providers to move voice and data packets on wireless and line systems.  Essentially every time someone uses their mobile phone (to make a call, send a text, surf the net or use an app) some sort of signally takes place.  Early mobile communications consisted mainly of voice, but with the advent of text messaging and smart phones, data now surpasses all voice and is expected to keep growing (pick a growth rate).  Consider the following:  smart phones (main data users) create 3-5x more signal traffic than voice and of the smart phones; the IPhone uses almost 5x more than any other.  Globally about 90% of the phones are voice/text, 10% smart.  North America has the largest penetration of smart phones at around 20%(ROW is between 0-7%).   Tekelec is by far the most dominant player in signaling systems owning 70% of a ~$600mm/year sector.

Currently signaling makes up almost 85% of all TKLC revenue but it's worth mentioning their main product is on a declining revenue curve and is likely to be non-existent in 10yrs.  As older technologies (2G and 3G) are replaced with LTE (or 4G) TKLC's main product (Eagle 5) will be out dated.  This is not as dire as it sounds as even LTE needs signaling systems and Tekelec is the leader with their Eagle XG product.  The risk is that all those adopting new systems don't use TKLC as the older product runs off.  In our view, and from those we have spoken to in the industry, this is a low probability given TKLC is the main signaling player and the competition has scaled back over the past few years.  To support this, YTD they have had some very big wins in new generation signaling systems.

2)      Policy:  not essential yet but most industry experts believe it will be within 5 years.  Policy software and systems is a way to track and organize all the features the provider can offer you over your phone - both chargeable and non-chargeable.  This bit of the industry is $200-300/year and expected to grow at about 25%/year.  We are not big fans of this type of research but according to Infonetics, the policy server market (fixed and mobile) on a global basis grew by roughly 65% to approximately $280M in 2010 and is estimated to grow to $1.4B by 2014. Tekelec has about 10-15% of this market.

3)      Subscriber Data Management (SDM):  The easiest way to think of SDM is systems and software that allow the provider to compile all the devices you currently use.  For example if you have a work mobile phone, a personal phone and an Ipad from the same service provider, they wouldn't know.  SDM would allow them to track your usage, increase your experience, compile billing and offer more products and services.  This sector runs at about $200mm/year and is expected to grow at around 50% for the first 3-5years.  Again, with a pinch of salt, Infonetics research expects worldwide SDM market to grow in the high double digits range for at least the next four years and reach close to $800M in 2013.  Tekelec's Blue Slice is the most dominant player in this market.  

One question we had after hearing about the growth in Policy and SDM was why TKLC's top line was not reflecting it?  Management provided the following:

• These are new technologies, only now being adopted
• Customers are buying the minimum right now because of the newness (apparently this is normal for new technologies where customers pause before adopting)
• General caution among service providers

Main competitors in these areas are:

Direct comparisons are difficult as none of the competitors above share more than one business area with Tekelec.

Tekelec's markets are competitively priced but there is little chance of price wars as customers rely a great deal on the credibility of the product and service.

From these products Tekelec generates revenue three ways:

1)      Product sales (68%)

2)      Professional Services (15%)

3)      Warranties (17%)

Note:  for the purposes of our analysis we used the last three years for averages unless guided by management.  Our rationale being it properly represents the company in its current state (including management).  Since 2006 the company has changed management and re-focused the business following a patch of bad leadership and acquisitions.

Product sales and professional services rely on the sale of new products; the warranty business is more of an annuity (further on that in the evaluation).  Tekelec generally deals with service providers over 3mm subscribers so their customer base is going to be made of the larger players and therefore concentrated.  In 2009, 79% of revenue was by wireless customers; YTD AT&T and Verizon account for 14% and 12% of sales, respectively.  The flip side of this is customers are extremely sticky.  To date Tekelec has not had a customer switch once their systems are installed.  This makes sense given the use of the product and as one industry person told us "signaling equipment is more like the brains than heart, and you can't do brain transplants".

Lead time for orders are generally around 6-9months so the book to bill ratio can be helpful.  At the end of Q2 2010 this stood at 0.7x.

Revenue is split 40% in the US and 60% ROW.

Gross revenue has averaged around 68%, management guides between 65-70%.

Expenses are straightforward with the bulk of them coming from R&D.  Sales and Marketing, Admin & General are variable with a relatively quick adjustment time.  R&D is much stickier and considered essential by the company.  Management has been very disciplined with expenses during the crisis and seems to make costs a top priority.

The Balance sheet is in good shape with $226mm of net cash.

TKLC has made two acquisitions this year totaling$165mm (paid for in cash):  Camiant ($130mm) and Blueslice Networks($35mm).  Both are considered strategic addressing the Policy and SDM areas of revenue.  Estimates for revenue are between $30-40mm in 2011 with correspondingly high growth rates as mentioned above.

Evaluation

Simple metrics:

P/B:  1.3x

LTM EV/EBIT:  6.61x

EV/3yr avg EBIT:  8.84x

Estimated 2010 EV/EBIT:  6.63x

Estimated 2011 EV/EBIT:  5.98x

Both the 2010, 2011 estimates do not include the recent acquisitions.

Working Capital:  $295mm

Net Working Capital:  $276mm

We also looked at Tekelec by considering the cash and annuity generated by the warranty business.  According to management if TKLC were to shut its doors today about $70mm in warranty revenue would come in for about 10yrs with a gross margin of "mid-sixties".  The costs of goods associated with the warranty are call center and parts/services.  We further deduct an estimated admin expenses (using current admin expense ratio) and figured for taxes (assuming 30%).

If this lasts about 10yrs and without any interest rate assumptions it should be worth about $248mm.

So to build out the rough value:

If the company stays on track to do about $55mm in operating after tax cash (net income+depn-capex), then we are paying a little over 10x after tax cash for a business that seems to have a good future.

Conclusion

We believe Tekelec represents a compelling value investment, providing capital protection and value from its operating business.  Good downside protection is generated from the net cash of $226mm plus annuity stream from its warranty business, creating a disaster value of $474mm.

From a valuation perspective, Tekelec business is cheap at 5.98X 2011 EV/EBIT and a book value of 1.3x, without considering any additional income from recent acquisitions which are expected to be accretive next year.  Up until April of this year the market was feeling pretty good about TKLC's future and valued it close to $20/share or about 75% higher from its current price.

Lastly, while there is much talk about the prospects in the wireless space it's generally difficult to apply these to the value approach.  We feel an investment in Tekelec gets exposure to this exciting area without paying up for technological expertise, growth or future assumptions.

Risks

• Credit contracts in EM and Middle East
• India contract delayed
• General economic conditions

• India contracts proceed
• Share buy-back (being discussed by the board)
• General economic conditions improve