Lark Research - Alcatel-Lucent Update - July 31, 2011 |
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Alcatel-Lucent (ALU) reported second quarter earnings of €0.02 per share, compared with a loss of €0.08 last year. Consensus estimates anticipated a small loss per share. Revenues increased 2.4% to €3.9 billion. Analysts were anticipating revenues slightly above €4.0 billion. Changes in foreign currency reduced revenues by €240 million. Management said that its transformation plan, which puts a priority on ALU's flexibility and ability to innovate, is on track. The company is benefiting from the growth in demand for video services in wireline and especially wireless networks. For ALU's customers, building the capability to accommodate this growing traffic is a necessity. ALU has positioned its product portfolio to capitalize on this trend and its efforts are now bearing fruit. Growth in video demand is a global phenomenon. The company is realizing growth across most of its product platforms and in many countries. In Networks, ALU's biggest business, revenues increased 7.4% to €2.48 billion. Within that business, IP products grew 27.7%, sparked by rising demand for its IP/MPLS service routers (which are the workhorses of IP-based network backbones). Optics revenues increased 3.7%, as the company's 100G technology has gained traction. ALU scored major contract wins in France, Hong Kong and Saudi Arabia and anticipates strong growth in Russia. Wireless revenues increased 5.7%, led by growth across the full range of network offerings, including CDMA EV-DO in the Americas, 2G and 3G in Asia/Pacific and 4G LTE globally. Wireline revenues declined 2.5%, as declines in legacy products were not yet completely offset by growth in new technologies, such as Passive Optical Networking. In Applications, revenues slipped 0.6%, due primarily to a 6.6% drop in Enterprise application revenues. However, most of the decline was offset by growth in Network applications, led by Digital Media & Advertising, Messaging and the Motive remote customer management offering. Services revenues also fell by 1.4%, as strong growth in two key businesses, Managed and Outsourcing Solutions and Network and Systems Integration was more than offset by declines in the Network Build & Implementation and Maintenance businesses. Most of the decline in NB&I was due to political unrest across North Africa. ALU sees good growth potential across many of its services businesses, especially in Strategic Industries, such as transportation, energy and the public sector. From a geographic perspective, growth remained strong in the Americas, but it has also picked up nicely in Asia/Pacific and the Rest of the World (ROW). In ROW, very strong growth in Latin America was offset partially by declines due to political unrest in the Middle East and north Africa. Europe remains essentially flat, but initiatives to implement a continent-wide framework for advanced telecommunications network architecture should facilitate a resumption of growth in time. Despite the modest growth in reported revenues, adjusted group operating income was up nearly four-fold from €28 million to €108 million. Surprisingly, operating income declined modestly in the Network groups, but increased sharply in Applications (reversing a prior year loss) and Services. Both higher volume and cost cutting paved the way for the profit improvement. On a consolidated basis, ALU's adjusted operating income increased from 0.7% in the 2010 second quarter to 2.8%. Based upon these results, management reaffirmed its guidance for all of 2011. It anticipates that revenues will grow faster than its addressable market (i.e. it will gain market share) and its adjusted operating margin will exceed 5%. Yet, ALU's stock fell 20% from $4.91 to $3.91 on the day of the earnings announcement. News reports attributed the reaction to a variety of factors, including missing on consensus revenues and analysts' disappointment with the full year outlook. From my perspective, the market's reaction can be attributed to the following factors: 1. Despite the four-fold jump in adjusted operating profits, the decline in Networks profits was both surprising and disappointing. Since revenues in that business rose 7.4%, I would have expected to see both an increase in operating profits and an increasing in operating margins. Management attributed the profit decline to China and a shift in product mix, but it declined to provide details. 2. With a reported adjusted operating profit margin of only 1.6% in the 2011 first half, the company must achieve very strong 2011 second half operating margins of 7.9%, according to my estimates, if it is to reach its full year 5% adjusted operating margin target. By comparison, its 2010 second half adjusted operating profit margin was 4.7%. This is a big improvement, but the first half 2011 adjusted operating profit margin improved 400 basis points (or four full percentage points) over the prior year. Profits are once again heavily weighted toward the back half of the year, but the company faces a relatively easy comparison in the third quarter. Given the risk of a slowing economy, especially in the U.S., and plans by major carriers, like Verizon and AT&T, to lower capital spending for the balance of the year, there are justifiable concerns about whether management can achieve its targets. So despite the earnings beat, much of which was attributable to pension and tax-related gains, it is likely that ALU fell somewhat short of many analysts' adjusted operating margin targets. Certainly, a stronger second quarter operating margin would have made the required ramp up in second half margins less steep. For its part, management did address many of these concerns during the conference call. For one, it says that the majority of savings anticipated by the company's ongoing restructuring program will be weighted toward the second half of the year. Furthermore, while it too has heard the statements by the major carriers of lower capital spending plans, it also knows the schedules for projects already underway. These were taken into account in reaffirming its full year guidance. In response to questions by analysts, CEO Ben Verwayen pointed out that the reaffirmation of guidance is based upon careful consideration of many factors, of which changes in customer spending plans are just one, that can affect full year revenues and profits. Seen in this light, the sharp decline in ALU's stock reflects once again some skepticism about whether management can deliver in the 2011 second half. Thus, we are facing to a slightly lesser degree a similar situation as in the Fall of 2010 when the market pummeled ALU's stock after a more disappointing quarterly earnings performance and despite management's reaffirmation of its full year 2010 guidance. In my previous report (December 2010), I had estimated the value of ALU at about $4.50 per share. After the company delivered on management's 2010 earnings guidance, the stock rocketed to a high of $6.63 in early May 2011. At that price, the implicit expectations about the company's future performance were simply too high. At the current price of $3.33 (8/19), however, I think that ALU offers very good value. Clearly, the company is hitting on many cylinders right now (management's words), with a full range of products that address the fastest growing segments of its target market. Assuming moderate and steady improvement in its performance going forward, I think that adjusted earnings of $0.45 per share are achievable in 2012, which gives the stock the potential to reach $6.00-$6.50 on a sustained basis within 12-18 months. This forecast assumes that the global economic recovery will continue. As long the recovery persists, I think that ALU can gain more market share as the demand for advanced telecommunications services grows. Over the longer-term, an increasing array of new applications will be built for many industries. As they are adopted, they will become essential services for their users and sources of new demand for ALU's products and services. For now, however, most of these video and other advanced applications are non-essential - many may even be viewed as frivolous - so that consumers may very well cut back on their spending quickly and sharply, if their paychecks are pinched. Barring a setback in the global economic recovery, therefore, ALU should be able to continue to grow its business. It has prepared well for the current phase of development of advanced telecommunication networks and related services. It is focusing its organization on becoming more flexible, so that it can anticipate new trends and create new products and services to meet future demand. Competition will always be tough and those competitors that seem to be behind today (e.g. Cisco) will undoubtedly begin to catch up before too long. Still, ALU is a sophisticated global company that is very well positioned to compete. Other Alcatel-Lucent Update Reports: Stephen P. Percoco © 2011, Lark Research, Inc. All rights reserved. Reproduction without permission is prohibited. Please note: This report and other reports on Alcatel-Lucent in this section on the Lark Research web site have been prepared for potentially interested parties in Lark Research's contract research services. Neither Lark Research nor Stephen P. Percoco have received any remuneration from Alcatel-Lucent for preparing these reports nor do they expect to receive any remuneration from Alcatel-Lucent in the future.
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