I have been watching Alcatel-Lucent (ALU) for a number of years now and waiting in anticipation for the company to turn into a prosperous telecom company. But the company appears to be in a "time loop" of never ending restructuring. As an investor, I look for a good reason to invest in the company and I have two choices.
Before Mr. Combes took over the reins at the company, Ben Verwaayen spent much of his time trying to keep a floundering vessel afloat. Years from now when we have the benefit of hindsight, the role he played may set the stage for a successful and profitable company under the reins of Michel Combes.
Presently I am looking at the basic financial information on the company over the last five years and I am concerned as an investor because the basic information is pointing out to me that ALU is unprofitable as soon as we get to "operating income" on the financial statement. We haven't even arrived at the concept of restructuring costs and other costs that the company has.
While the company's revenue levels, cost of sales, and gross profits remain relatively even, I am noticing that general administration and R&D eat up the rest of the company's revenue and it has barely squeaked out any profit in the last five years. What has worried me as an investor is the fact that these are fundamental numbers. Every company needs to have a positive cash flow when it comes to operating income.
So I asked myself if cost of sales was too expensive and if the company needed to reduce these costs. When I look at a competitor like Ericsson (ERIC) who is doing quite well, its (COS) percentages are about the same.
Ericsson's cost of sales practically mirror ALU's when we look at both of them as a percentage of revenue. My observations are telling me that cost of sales is not the problem for the company since a rival can still make a profit.
The only other two cost factors basic to operating income is administrative and R&D. ERIC has these costs but the company continues to be profitable year after year.
When I am looking at this from a "percentage standpoint," the revenue levels are not as important as the final results of operating income. If Ericsson can be in the black after admin and R&D expenses, then it looks like ALU's (Admin and R&D) expenses are going to have to come down in order for the company to consistently profitable. The company's loss is evident even before other expenses like, but not limited to, restructuring and impairment of assets are taken into account.
Even though I may l be interested in Alcatel-Lucent as an investment, I need to know what the company is doing to make itself profitable and reduce these basic expenses. I have been self-employed my whole life. I understand the need to increase revenue and at the same time reduce my expenses. Common sense would tell me to focus my energies on the areas that I can make the most money and reduce the expenses that contribute very little to my revenue source. I believe Mr. Combes is communicating that to us when he laid out his plan to bring the company into profitability within the next 2.5 years.
His plan to stop this "continual restructuring" and return the company to profitability has these objectives over the next 2.5 years:
- Restructure around a limited number of businesses that provide growth and profitability.
- Restore free cash flow.
- Reduce debt by €2 billion (€1 billion in sales plus other similar cost reductions).
- Narrow R&D adjusted to focus on two main businesses: IP Networking and Ultra-broadband Access.
IP Networking is expected to generate revenue while the broadband is for quick cash. It's the latter that represents a challenge as it tries to compete with the two largest companies that have stolen its business over the last five years; Ericsson and Huawei.
After a couple years, when the company has rid itself of most of its non-core operations, it is expecting to achieve positive cash flow. As this "cash decline" is reversed the company will also be reducing the €2 billion in debt that I described earlier.
In the short term, the company will refinance $2.68 billion in a debt repair loan it secured in January. It could also raise the same amount of money to repay those debts.
If I can liken ALU to a floundering ship on the sea, I would say that Ben Verwaayen spent the last couple years as CEO patching the holes that would sink the ship. He really never had the opportunity to set sails. Building off his "attempt to keep the ship from sinking" Mr. Combes is ready to prepare to ship for sailing.
The IP Networking division will be looked upon to be the main hub of growth for the company over the next few years. This is a broad division which encompasses things like: optical transport, IMS, VoLTE platforms, CloudBand cloud systems. Its strategy here will be to focus on some key IP platforms where it has maintained a high quality of excellence such as its carrier routers and emerging base stations. Where there are gaps, the company will seek strategic partnerships.
To show how the company expects things to change, this is what it forecasted for the IP Networking division over the next couple years. In 2012, it totaled sales of $8.2 billion with an operating margin of 2.4%. By 2015 the company expects sales of $9.4 billion with a margin of 12.5%.
The Access division is not necessarily expected to increase sales as much as the focus will be on creating cash flow and profit. This is what I meant when I described it as being "managed for cash." The main areas of emphasis here will be placed on LTE and PON fiber. Part of the main reduction in R&D will be in this division as the company plans to drastically reduce spending in legacy technologies (2G/3G and PSTN) to focus on the company's newer technologies.
A Sensible Approach to Investing in Alcatel-Lucent
If I am interested in investing in ALU, I see two choices that stand before me. My first choice would be to believe that Mr. Combes can "repair the ship for sailing" as he follows in the footsteps of Mr. Verwaayen's work before him. If I embrace this choice, I also must be prepared to limit my expectations for the next 2 ½ years. Mr. Combes has communicated that it will take that long to deliver on his promises. My second choice is to continue to watch the company and observe how his promises to bring the company to profitability are panning out. Theoretically investment toward the end of the 2015 would be more conceivable with the second choice.
Author's note: the statistics in this article on both Alcatel-Lucent and Ericsson were taken from each company's annual reports. All charts in this article were created from the statistics by the author.