Lark Research - Alcatel-Lucent Update - August 6, 2010

Back<<

On July 30, Alcatel-Lucent reported a a second quarter loss of €0.08 per share (or $0.10 per ADS).  That compares with a profit of €0.01 per share ($0.01 per ADS) in the 2009 second quarter.  This also represented a significant improvement over the loss of €0.23 per share ($0.31 per ADS) reported in the 2010 first quarter.

Second quarter revenues of €3.813 billion were down 2.4% from last year, but up 17.4% sequentially.

Despite the loss, the market breathed a collective sigh of relief because of the improvement over what was seen as dismal 2010 first quarter results.  At that time, management said that revenues were hurt by certain key parts and components shortages.  Although it said that it expected to see those sales come through in the second quarter, investors were apparently skeptical and drove its share price down 14% to around $2.30 on May 6, the day that first quarter earnings were reported.

On the second quarter news, the stock recovered all of that lost ground, rising to a high of $3.08 on July 30.  It has mostly held its ground since then, although it is down some 2% today to $2.97 in a weak market.

Since I issued my primary report on ALU in September 2009, the stock's performance has been disappointing.  I had anticipated that ALU would benefit from the restoration of capital spending budgets and increased spending from its core telecommunications carrier customers worldwide as the economy recovery began to take hold.  That increase in spending did not materialize in the final two quarters of 2009 and was delayed, as discussed above, in the 2010 first quarter.  Even with a modest 2010 second quarter rebound, revenues still lagged the prior year's total.  However, the company said that its order book is strong and so it anticipates steady improvement in its business for the remainder of the year.

Segment performance breaks down as follows:

Networks.  Of the three segments, this appears to be the best positioned.  The IP division, which makes routers, switches and related products for big telecom carriers, saw revenues rise 11.2% year-over-year.  The division generated €55 million in operating profits, compared with a €136 million operating loss last year.  Despite heavy competition from the likes of Cisco, Juniper, Huawei and others, ALU's products are holding there own.  Many carriers are focused on rebuilding and expanding capacity in their core backhaul networks.  ALU was selected by AT&T as one of its Domain suppliers for its IP equipment upgrade.

The Wireless division posted a 5% revenue gain due mostly to growth in its WCDMA business in North America.  Its CDMA business is also benefiting from carrier spending to expand data capacity on 3G CDMA (EV-DO) networks.

Growth in Wireless and IP was offset by declines in Optics and Wireline.  The Optics division suffered a double-digit earnings drop due to the completion of several large submarine projects.  Increases in terrestrial optics revenues, with the help of new product offerings, were not enough to offset the decline in submarine.  Yet, the company said that new projects are getting underway and some have been delayed, so the hope is that this business will show improvement in time.

The Wireline business, on the other hand, has seen a steady erosion in its revenues, as customers transition away from legacy systems.  While the decline may possible slow from the second quarter's -13.7% pace, it is likely to continue for some time going forward.

Applications.  Segment revenues increased 5.8%, while the operating loss narrowed from €30 million to €17 million in the 2010 second quarter.  Network applications benefited from strong demand for specialized services, such as customized software, digital media & advertising and subscriber data management.  Enterprise applications saw only a modest pick-up in demand as corporate spending remains tight.  Although the HP alliance has begun to win new business, it is not clear when and whether this division will demonstrate a sustainable level of acceptable profitability.  To some degree, these products help strengthen ALU's relationships with the major telecommunication carriers.  On the other hand, unless the division can get generate acceptable profits, the company may eventually move to scale back the business.  For now, however, management is willing to give the Applications division time to prove its value.

Services.  This division has traditionally been a steady performer, but its second quarter results were surprisingly weak.  Revenues increased 1.1% in the quarter, but operating income declined from €87 million to €19 million.  Managed and Outsourcing Solutions saw revenues fall at a moderate rate, as some companies delayed implementation due to the uncertain economic environment.  Multi-vendor Maintenance also, somewhat surprisingly, suffered a revenue decline as customers cut back on their maintenance spending for ALU products.  On the other side, order growth was strong in both the Network and Systems Integration and the Network Build and Implementation businesses, which suggests that the Services division should see further improvement in the quarters ahead.

On balance, therefore, while second quarter revenues still lag prior year totals, operating profits improved significantly, especially compared to the 2010 first quarter.  Demand for telecommunications products and services is rising because of increased data traffic and the need for carriers to improve network efficiency.  As a result, ALU has seen its order backlogs improve meaningfully, especially in certain businesses within its Networks and Services divisions.  While supplier shortages remain a concern, the company has boosted its inventories recently to meet customer demand.  Thus, I expect to see further improvement in ALU's revenues and operating profits in the second half of the year.

On that score, management reiterated its expectation of 0%-5% growth in overall industry revenues and reaffirmed its guidance of reaching an adjusted operating margin of between 1% and 5%.  Assuming that the company grows revenue in line with its expectations for the industry, I project that it can achieve breakeven earnings on a per share basis for 2010 and earnings of €0.20 per share or more in 2011.  That projection assumes that the global economy does not suffer a relapse which would cause ALU's customers to slow or delay project roll-outs.

From a cash flow perspective, ALU reported that its cash and marketable securities declined by €466 million in the quarter, mostly because of a  €202 million increase in operating working capital requirements related to the build-up of parts and components inventories that had been in short supply.  While the company said that the parts shortage has not gone away completely, I anticipate that need to expand operating capital will ease; and assuming that profitability improves, so should ALU's cash flow in the quarters ahead.

Improved financial performance will hopefully allow the company to continue to extend its debt maturities.  ALU has €818 million of OCEANE 4.75% coming due in January 2011.  (OCEANE is a type of convertible debt.)  Although it appears to have enough cash and marketable securities on hand - €4.84 billion - to meet this debt payment, the company would probably prefer to issue new debt in order to maintain a large cash cushion.  If it is able to demonstrate improved performance in the next two quarters, it should be able to get an attractive rate on a new debt issue.  After that, the company faces the maturity of €462 million of 4.75% Notes issued by Alcatel-Lucent in April 2014 and a potential put of $638 million of 2.875% Series B Convertible Senior Debentures originally issued by Lucent Technologies in June 2013.  Those debentures recently traded at around 89 which represents a yield of about 7% to the June 2013 put.

While ALU's financial performance has been disappointing until the most recent quarter, there are signs that the company has made good progress in shoring up its competitive position.  Last year, there were widespread concerns that ALU's product offering in 4G LTE wireless lagged the competition, especially Ericcson.  Since then, ALU has gained significant experience in expanding AT&T's 3G HSPA+ wireless network, which was struggling in key metropolitan areas to keep up with the incredibly high demand from iPhone users.  Recent reports suggest that most of these problems have been resolved.  By working closely with AT&T during this process, ALU has undoubtedly gained significant experience which will benefit future HSPA+ installations and upgrades and also the eventual rollout of LTE.  So while the consensus view is that ALU is still somewhat behind the competition, I suspect that it has caught up considerably over the past year or so.

Although improved financial performance appears to be a good bet for at least the next couple of quarters, any further gains beyond that will of course depend upon the state of the global economy.  Even with the tepid growth and fears of a slowdown that we have experienced recently, it appears that demand for bandwidth, from computers, smartphones and an expanding array of devices, remains quite strong.  For the most part, however, spending on advanced telecommunications services is highly discretionary, so that demand could fall sharply, if the global economy collapses.  In that case, it could be years before the the global build-out of these networks is completed.  This, in my view, is the primary longer-term downside risk that ALU shareholders face.

August 6, 2010

Stephen P. Percoco
Lark Research, Inc.
P.O. Box 768
Norwood, MA  02062

(732) 763-0763
webmaster@larkresearch.com

Back<<

Please send your comments and suggestions to: webmaster@larkresearch.com.