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Introduction

Alcatel-Lucent (NYSE:ALU) is one of the largest telecom equipment providers in the world with annual sales of ~$20 billion. The company was formed in 2006 by the merger of French company Alcatel and U.S. company Lucent Technologies. The company has a long heritage of telecom product development and possesses one of the largest telecom patent portfolios. ALU and other top Western telecom equipment companies like Nokia-Siemens and Ericsson (NASDAQ:ERIC) have seen their profits plummet due to the advent of the Chinese telecom giants such as Huawei and ZTE. These companies have captured significant global market share from the western manufacturers through undercutting of the market leaders. This has been one of the primary reasons why ALU shares have fallen so drastically. The company's management has been cutting costs and selling assets in order to return to profitability. However, their efforts have not borne fruit to date as the company showed ~1.6 billion euros (US$2.05 billion) in operating losses in 2012. The company's stock doubled after the company managed to raise capital in late 2012. However the shares have gone back near the all-time lows as the company's recent quarterly reports did not generate much confidence. I think that the stock price currently offers little danger of falling much and has the potential to go up, if the new management cuts unprofitable divisions. That said the stock is not for a risk-averse investor but more for speculative buyers looking at turnaround plays.

What could turn around Alcatel-Lucent

  1. Merger Possibilities - The telecom equipment industry has seen considerable consolidation over the last decade with the merger of the big firms. Nokia merged its telecom equipment arm with Siemens, while ALU was itself formed by the merger of Lucent and Alcatel. Companies in the sector are still facing major profitability issues and more consolidation can be expected. Nokia-Siemens is looking to merge itself with either of the two remaining big western telecom equipment makers. Neither Nokia (NYSE:NOK) nor Siemens (SI) has much interest in continuing with the telecom equipment JV. ALU with its small market capitalization forms a more attractive target for Nokia-Siemens.
  2. R&D Strength - Alcatel-Lucent has one of the strongest research departments in the industry and spends almost $3 billion every year on R&D. The company managed to secure a loan by putting up a part of its R&D portfolio as collateral. The Telecom companies have seen big acquisitions in recent times mainly due to their patent portfolios. As technology giants like Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) step up their patent wars, large patent portfolios are becoming increasingly valuable.
  3. Backlash against Chinese telecom firms - Countries are getting increasingly concerned about the close ties of Chinese firms like ZTE and Huawei with the Chinese government. Security agencies are concerned about sensitive telecom equipment being installed by the companies with close ties to the Chinese government. India too has been putting barriers on expansion by Huawei due to security reasons. The western media have been repeatedly publishing stories about cyber-attacks originating from rogue Chinese elements. The U.S. recently passed a law restricting Chinese technology imports. This should benefit western companies that have been battered by the competition from the Chinese giants.
  4. New Management - The current CEO Ben Verwaayen is stepping down and ALU is appointing a new CEO in April. This can serve as a positive catalyst which can change the company's downward trajectory. Yahoo (YHOO) has seen a considerable improvement after the appointment for Marissa Meyer. A new management can bring fresh perspective and energy, which is desperately needed in the case of ALU. The company is large and bureaucratic and needs a strong leadership, which can wield the scalpel.
  5. Cutting of high-cost unprofitable areas - Despite selling off non-core assets in the last few years, ALU is still saddled with a lot of nonviable products. For example it would surprise readers that ALU still makes smartphones. Siemens and Ericsson realized that they could never compete effectively in the mobile phone markets and have hived off their mobile divisions. With miniscule market share, it does not make any sense for ALU to continue in the hyper competitive mobile devices market.
  6. New Deals - Alcatel recently announced a number of large telecom equipment supply contracts. The company is working with China Mobile (NYSE:CHL) for 4G-LTE deployment, while it has an agreement with Telenor (OTCPK:TELNY) for providing telecom infrastructure in India. ALU beat Ericsson to win a $1 billion, eight-year contract with the Indian telecom company Reliance Communications to manage its wire line and wireless network. The company has also signed up with New Zealand's biggest carrier Chorus New Zealand, to provide fiber services. Alcatel also won a big contract with Belgium telecom company Belgacom.
  7. Adverse Sentiment - The sentiment towards ALU remains highly negative with investors seeing a huge part of their investment wiped out by the stock decline. Analysts are not confident about the company being able to turn around, with most recommending a hold if not a sell rating. There is a concern about the French government buying a stake in the company, which will give the government a bigger say in running of the company's affairs. Given the government's anti-business socialist tendencies, this will not be a positive event for the shareholders. There are also concerns whether the new CEO can put the company on the path to profits.
  8. Cheap Valuation - ALU stock trades at a significant discount to the rest of the industry with a P/S of just 0.2x and P/B of 1.2x. This compares with the industry average of 1.6x and 2.2x respectively. The reason for the low valuation is the company's lack of profitability and high level of debt. Once the company manages to get back on track, the valuation should move up to the industry averages.

Alcatel-Lucent Risks

a) Huge Debt and Cash Flow problems - Alcatel has significant debt and pension liabilities as the company has been losing money in the last few years. The company faced a serious liquidity crunch before it managed to raise debt from a consortium of investment banks. In December, Alcatel secured a $2.6 billion credit facility to help it refinance debt and cut costs. The company's balance sheet remains stressed and limits the company's options.

b) European Economy is stuck in a Rut - The European economy remains a basket case with many big economies contracting, due to austerity measures imposed because of the debt crisis. It is hard for the telecom carriers to maintain/ increase their capex in such an environment. Though ALU has a global footprint, Europe remains one of its biggest markets and the company will be adversely affected if the European economy goes further downhill.

c) French government interference - Recent moves by the French government have not been business friendly. The Hollande government has been stopping companies from firing workers and closing plants. This is not a happy situation for ALU, which is already under severe distress. There is speculation that the French government might buy a stake in the company to bolster its flagging position. The French leaders were not happy with ALU putting up its patent portfolio as collateral, for a $2.6 billion loan arranged by investment banks. The last thing that ALU needs now is interference from politicians with a socialist agenda.

d) Decreasing Revenues and Profits - ALU's revenue has been declining over the past few years as the competition has been eating up its market share. Total sales have fallen from ~17 billion euros in 2008 to ~14.5 billion euros in 2012.

Stock Performance has been quite bad

Alcatel-Lucent stock has fallen off a cliff from the all-time highs it reached during the 2000 Technology Bubble. The stock has lost almost 99% of its all-time high value of ~$85 reached during 2000. The stock has been on a constant downtrend since that time. The stock has lost over 3/4th of its value in the last five years and has been amongst the worst performing telecom equipment stocks in this time frame. While ERIC has gained ~32%, Cisco (NASDAQ:CSCO) and Juniper Networks Inc. (NYSE:JNPR) have lost ~13% and 23% during this period. ALU had gone up by almost ~90% from its all-time lows of 91cents during January 2011. The stock has pulled back since then, to $1.33 currently. ALU stock has shown high volatility and will continue to do so in the near future. The stock is recommended only for those with a high risk appetite.

Summary

I like Alcatel-Lucent mainly because of its very cheap valuation and potential for making a turnaround. It is not a stock for a risk-averse investor as it shows considerable volatility. However, ALU trades at a very cheap valuation based on P/S and P/B ratios. If the management is able to cut off the unprofitable parts and focus on its core strengths, then ALU stock has the potential to be a multi-bagger. The company has one of the strongest R&D portfolios in the telecom industry and still manages to sell $20 billion in telecom equipment each year. The stock has a very small market capitalization of just $3.5 billion. If it manages to get its act together, it could see its share price multiply to match the current valuation being given to peers like Ericsson.

Source: 8 Reasons To Buy The Fallen French Giant