Comverse: Mgmt Meetings Stress Excellent Trends/Visibility; Buy (Pt 2/2)
(CONTINUED FROM PART 1)
Spinoff of Comverse Info Systems Could Increase Corporate Growth Rate
Investors may be encouraged by management's confirmation that it is considering the possible spinoff of the company's Converse Information Systems (CIS) division in 1999. The CIS division -- which we estimate at around 9%-10% of revenues -- is made up of Comverse's governmental recording business, which uses the AudioDisk brand name, along with the commercial voice recording unit, which targets the call center market using the Ultra platform. While we maintain this unit has significant potential in both the government recording market and the call center arena a number of factors -- including the impact of legislative delays on the U.S. government market -- have meant that revenue growth from CIS has been in a 10%-20% range. This is somewhat lower than the 25%-35% growth rates seen in the Network Systems area. We think that the CIS unit could benefit from being more tightly focused as an independent entity. At the same time, Comverse's overall revenue growth rate might trend upward if the company was exclusively targeting the enhanced services market.
DGM&S Division May Also Be Heading for Independence
Management also highlighted that its fast growing software solutions unit known as DGM&S could also be spun off as an independent entity. DGM&S was acquired by Comverse in 1995 and has grown to an estimated sales level of around $20 million in 1998 -- up roughly 40% year over year. The unit has emerged as a leading supplier of SS7 and other high-value-added software solutions, selling to a long list of operators and equipment vendors. While Comverse would clearly retain a majority stake in DGM&S, we contend that the business could benefit from the perception of greater independence -- particularly in its efforts to sell to other equipment companies. While we do not view the spinoff as imminent, it appears that DGM&S could return to independence at some point in FY99.
Asian Sales Appear to Be Stabilizing
Our discussions with management also appeared to endorse our view that the company's sales into Asia may be stabilizing. Sales to Asia trended upward in 3Q98 to around 16% of total revenues $28 million versus approximately $23 million in 2Q98. In addition to the 3%-4% of sales in China and 6% in Japan which have remained relatively steady markets, it now appears that Comverse is seeing some modestly improving trends in Taiwan, Australia, Singapore and Korea. Management highlighted that despite winning several awards in Brazil and Mexico in recent months, it expects growth in Latin America to lag behind the pace of expansion in Europe and the U.S. in 1999, with these two regions likely to remain the key growth engines.
Stock Opinion: Comverse Remains a Top Pick in Telecom Equipment
Following strong recent 3Q98 results, with the company beating the consensus expectations (for the eighteenth quarter in a row) we raised our estimates once more. Our FY98 earnings estimates moved to $2.31 and our FY99 estimates increased to $2.77. We also introduced an initial 2000 estimate of $3.32. Our revenue estimates are $695 million in FY98, $835 million in FY99 and approximately $989 million in FY00. Our confidence in these estimates moving upward over the course of 1999 partially reflects Comverse's improving gross margin outlook as the company sees improving volumes, increased manufacturing efficiencies and a higher level of repeat sales to existing customers. As highlighted earlier, we believe that our 60.2% estimate for FY99 could prove conservative given an increasingly large percentage of software in Comverse's product mix. We have also been encouraged by the rising backlog levels and Comverse's ability to continue to extend its market share despite the release of an improved competitive offering from Octel/Lucent in the form of the new IMA platform. We believe Comverse is seeing strong new business win rates, with the addition of approximately seven new customers in 3Q98.
Comverse's core Network Systems is likely to continue to benefit from the expanding demand from wireline and wireless telecom service providers that are seeking to add revenue-generating enhanced services such as voicemail and information services. Meanwhile, the Comverse Information Systems division is well placed to exploit the transition from analog to digital recording and monitoring systems by both government agencies and corporations.
We contend that Comverse's valuation remains compelling at 25 times our conservative calendar 1999 estimates. Our price target of $85 is based on our view that over the next 12 months investors are likely to focus on the company's earnings growth in excess of 25%, allowing the shares to achieve a multiple of approximately 25 times our conservative calendar 2000 estimate of $3.32.
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