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We are adding Openwave ( OPWV) to our watch list.

We believe that shares, which closed Thursday at $7.77, are discounting a number of negative data points and that upside will be driven by strong demand for mobile 3G wireless services and music downloads to mobile phones. However, management has lost some credibility because of a large earnings warning Thursday, and we will wait for weakness closer to the $6 level before initiating a position.

Openwave, a potential Inflection Point play -- a stock with a broken business model that's on the mend but has yet to be recognized by the market -- in our proprietary rating system, lost 32% in trading Thursday after the company preannounced a large fiscal fourth-quarter earnings and revenue shortfall.

We've had Openwave on our radar screen for the past two weeks and were expecting the company to miss the Street's expectations this quarter; we believed that would create a compelling entry point for investors with long-term time horizons.

With our thesis playing out as expected, we believe that shares are approaching an attractive level for investors and that valuation will support the stock if it drops closer to the $6 level. The company will report earnings Sept. 12.

Openwave generates revenue through the sale of software that enables text messaging and email over wireless networks to cell phones. In addition, the company sells software that is installed on cell phones to enable Web browsing. Thanks to its recent acquisition of Musiwave, Openwave also distributes media content, such as music and video, to cell phones.

The company is dependent on a few large customers for revenue, with Sprint Nextel ( S), Cingular and Motorola ( MOT) representing some 43% of total revenue in the first quarter of 2006. Openwave's total gross margins hover in the 70% range. License revenue carries gross margins closer to 95%, while recurring service revenue, which is provided as part of the company's license agreements, has gross margins closer to 20%.

However, a quick look at Openwave's lowered fiscal fourth-quarter earnings outlook offers investors little to get excited about. The company now expects break-even earnings results for its latest quarter (ended in June) vs. the Street's consensus of 22 cents a share, with revenue of $90 million to $92 million falling well short of analyst projections of $121.9 million.

For fiscal 2006, Openwave is looking for earnings per share (EPS) of 58 cents to 60 cents vs. the $1.12 analyst consensus, with revenue forecast to come in at $410 million, well below the Street's $442.6 million estimate. For fiscal 2007, the company expects EPS of 58 cents to 62 cents on revenue of $430 million to $460 million. Analysts are forecasting EPS of $1.03 on revenue of $562 million.

Even before Thursday's warning, the Street already had a negative stance on Openwave's fiscal fourth-quarter earnings potential for a number of reasons, with shares down some 60% since April.

  • First, Openwave hasn't announced any new contracts with wireless carriers or handset manufacturers this year, despite previously stated plans on its most recent conference call to announce three new contracts.
  • Second, during the past 12 months, the company has grown dependent on large deals at the end of most quarters to meet consensus forecasts, and that raises the potential for earnings misses. Openwave's days sales outstanding (DSO) -- the average number of days that customers take to pay their bill -- has been rising over the past five quarters despite comments from management that the DSO number should be declining. This disconnect raises concerns about the structure of the company's contracts and possible concessions that may have been required in order to close deals at the end of a quarter.
  • Last, Openwave is under investigation by the Securities and Exchange Commission for options backdating.

Another issue for the company is its struggle to integrate Musiwave, which provides wireless carriers with content, such as music for cell-phone handsets. We believe Musiwave, which Openwave bought in September 2005 -- it closed the deal in early 2006 -- was partly to blame for its warning on fiscal fourth-quarter earnings results.

Management noted that traffic to Musiwave's Web portal declined in May, with only a modest recovery in traffic rates during June. Musiwave depends on visitors to the Web portal for its top-line growth, so any slowdown in the rate of traffic growth would have a material impact on Musiwave's revenue.

On the positive side, Openwave announced a $13 million contract this morning with an undisclosed party, which is a step in the right direction -- albeit still not enough to make up such a significant reduction in earnings guidance. The company also said it recorded strong sales bookings of $122 million in the quarter, which should show up as revenue in the coming quarters.

Even so, this marked a small decline in sales bookings from year-ago levels, and the company's ability to rebuild its sales bookings momentum in the coming quarters will be a key determinant in any operational turnaround. However, management's disclosure that there are five to six more potential deals in the pipeline increases our confidence that the company will show steady growth in sales bookings in coming quarters.

Another positive is robust end-market demand for wireless broadband connectivity, which we believe has the potential to spur fiscal 2007 revenue results above Openwave's guidance. Global cell-phone handset shipments should eclipse the 1 billion mark in 2006 and continue growing in 2007 and beyond. Openwave's 50% market share of the wireless Internet browser market should help the company exploit this strong industry growth trend. In addition, the Musiwave acquisition could turn out to be very profitable for the company as more wireless users become acclimated to downloading music over the airwaves to their cell phones.

While we are cautiously optimistic that down the road Openwave will deliver results exceeding its fiscal 2007 forecast, we would like to see valuation improve a bit before trying to catch this falling knife. At current levels, shares are trading at 14 times the Street's fiscal 2007 EPS forecast on a price-to-earnings (P/E) basis and just 10 times 2007 analyst forecasts after backing out the company's net cash balance and stripping interest income from EPS.

At $6, though, shares would be trading at just 10 times 2007 EPS forecasts on a P/E basis and 6.5 times after accounting for net cash and interest income. Given the company's earnings warning, we believe management's declining credibility will be better priced in with the stock trading closer to a single-digit P/E multiple.

Another factor in considering valuation is that Openwave is not a large cash taxpayer at present. The company has about $400 million in net operating losses that it will be able to use in future periods to keep its cash tax expense lower than its generally accepted accounting principles (GAAP) tax rate. This should keep cash earnings above Openwave's reported EPS on the income statement for the foreseeable future.

We will monitor Openwave for opportunities to establish a position at better prices, but we believe shares still have some downside ahead.
William Gabrielski is a research analyst at TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gabrielski welcomes your feedback; click here to send him an email.

Interested in more writings from William Gabrielski? Check out Stocks Under $10 and TheStreet.com Breakout Stocks.

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