Shares of Telecom equipment maker, Alcatel Lucent (ALU), have traded up almost 13% after its announcement of a 1.6 billion euro ($2.1 billion) financing agreement. However, this recent boost is likely to be short lived, as the company has some serious challenges ahead. Intense competition from low-cost equipment makers and weaker spending by global telecom carriers on their respective networks are major reasons behind the company's falling revenues and contracting gross and operating margins.
LTE rollout spending is a positive for Alcatel, however, it will largely be offset by its weak CDMA positioning. Moreover, operating cash flows continue to remain under constant pressure, as the company burns cash year after year. Even though AT&T's (T) plans to upgrade its wireline network and the recent credit facility are events that are positive for Alcatel, these developments do not solve the operational challenges the company faces. As such, I am doubtful that the company will be able to turn profitable on a consistent basis in the short to medium term, and recommend investors to take a short position in the stock.
Since 2007, revenues have declined from 17.8 billion euros to 15 billion euros in 2011, which represents a CAGR decline of over 4%, and given the performance in the first three quarters (a 3% decline in revenues in Q3 2012) of the current year, it is very likely that the company will end another year with no growth in its revenue base.
Weak Wireless Infrastructure Position
The wireless segment reported a 19% decrease in revenues from the year ago quarter. Management mentioned in its latest earnings release that a declining CDMA/GSM market is causing a major erosion in sales. These pressures will continue in the future, and the company is likely to lose more market share in the wireless infrastructure market, largely due to its weak position in CDMA and HSPA. Despite the fact that it is seeing good results due to the LTE rollout by companies like AT&T, Verizon (VZ) and Sprint (S), these rollout expenditures will most likely not be enough to offset the weakness in the CDMA technology, and bring about a slowdown in the consistent revenue decline.
Weak Optic Business
Optic sales have declined at a CAGR of over 6% since FY 2007. Since various telecom carriers around the world are spending more on their wireless networks rather than fixed networks, Alcatel's optic business will continue to suffer from this shift in spending to wireless infrastructure. Even though there has been some growth in its terrestrial optic products, it has been largely offset by the deterioration in its submarine division. Optic revenues were down 20% in the first half of the year and the third quarter continued on the downward trend, reporting a decrease in revenues of 18% compared to Q3 2011.
Apart from the growth in IP business, where the company recorded a robust growth of 30%, the results were disappointing and point towards even more disappointing results in the last quarter of the year.
The company has been reporting a consistent contraction in its gross and operating margins, which is a serious concern. Management set a rather ambitious target of reaching 2012 operating margins of almost 4% at the start of the year. However, after the weak operational performance in the first half, it announced that the set target would not be achievable. Moreover, looking at the results of the first three quarters, it is very likely that the company would not be able to even post an operating margin of 1% in the current year.
Serious Liquidity Concerns
Despite the breathing space provided to the company by the recent 1.6 billion euro financing arrangement, the company needs to eventually start generating positive cash flows, which has been lacking for a number of years now. Perhaps the most disappointing metric in the latest earnings release was its continued cash burn level. In the third quarter, the company burned cash of 320 million euros, with high operating losses and finance costs leading to a negative free cash flow of 360 million euros. Even though the company ended the third quarter with 4.7 billion euros in cash, its total debt stood at 4.8 billion euros. In fact, Alcatel has 814 million euros in debt that is due within the next 12 months, and approximately 2.5 billion euros due between now and start of the financial year 2015, some of which will be refinanced. Given the company's inability to produce positive cash flows consistently, coupled with the high level of cash burn, the company has very limited financial flexibility as far as its debt payments are concerned.
ALU is trading at cheap valuations, as reflected in its price to sales ratio of only 0.13x. However, in the absence of revenue growth along with a consistent cash burn, these cheap valuations are justified. Moreover, earnings growth expectations of -26% over the next five years suggest why the stock is so inexpensive.
ALU currently has 2.27 billion shares outstanding, with a sales per share of $8.19, according to 2013 consensus sales estimates of $18.61 billion . In a bullish scenario, applying a forward price to sales multiple of 0.15x, I arrive a target price of $1.24, which is where the stock is currently trading, indicating the stock is fairly valued at this level. In a bearish scenario and applying price to sales of 0.13x, target price comes out to be $1.06, which is a downside of almost 15%. Unless the company can bring about any meaningful reversal in its operating margin and cash burn, there is still more downside to the stock price than upside.