Alcatel-Lucent (ALU), formed through a merger of Alcatel and Lucent Technologies in 2006, has been suffering from decline in its top line. The top line has declined from $21.01 billion in 2010 to $19.05 billion in 2012. This decline was due to the growing competition from Chinese vendors like Huawei and ZTE (OTCPK:ZTCOF). To revive the company's fortunes Michael Combes, the newly appointed CEO, announced the Shift Plan in June this year. This plan was aimed at restructuring Alcatel-Lucent and focuses on increasing its core networking business' revenue by over 15% from 2013-2015. This growth is expected to come from initiatives implemented towards the development of products which are innovative and can cater to the growing demand in the communication industry. The company has taken initiatives to set the platform for this Shift Plan. In addition, the company is also betting on contracts from adoption of 4G technology in countries like China. These contracts are expected to support Alcatel-Lucent's turnaround strategy. Let's discuss these in detail.
Strategic partnership for boosting R&D
On June 30 this year, Alcatel-Lucent announced a strategic partnership with Qualcomm (QCOM) to develop small cell base stations, which improve wireless 3G, 4G, and WiFi networks across residential and commercial areas. These are compact machines, which are placed on buildings to improve internet connectivity. The partnership will result in both companies investing a total $132 million in R&D for developing next generation Alcatel-Lucent's lightRadio small cell products featuring Qualcomm's chipsets. This initiative is part of its shift plan, in which the company is focusing on increasing its R&D for developing products that cater to new technology.
Alcatel-Lucent is expected to take 95% stake in this partnership. Small cell base stations are in demand as they are compact and consume less space than large base stations or cell site, and due to growing internet usage, telecom service providers prefer this equipment for better connectivity for data traffic. Telecom service provider Verizon (VZ) has started using this technology for their existing networks, and Verizon is expected to deploy 200 small base stations this year. Another major telecom player, AT&T (T), plans to deploy 40,000 small cell base stations by 2015.
This partnership is expected to help Alcatel-Lucent post top line growth, which is expected to reduce the company's net loss that increased to $1.17 billion in second quarter of this year. Despite the current losses, we expect that small cell station base demand will provide good opportunity for the company to generate earnings for the shareholders in the future.
4G, the next growth driver
Alcatel-Lucent, leader in CDMA network solution with 37% market share, is betting big on China's 4G market. Recently, the world's biggest mobile operator in terms of subscribers, China Mobile (CHL), awarded $3.2 billion in initial 4G contracts to Chinese and European vendors, with Alcatel-Lucent getting 10% share in the contract. The contract was signed for supplying 4G base stations, which are used to broadcast mobile signals.
Alcatel struggled last year in terms of revenue from its China division, declining 16% year over year in 2012 due to decreased spending by Chinese telecom operators. But with the China 4G license auction expected to come by year end, the company is expected to gain more contracts, thus bringing revenue growth from the world's biggest telecom market. 4G being a next big growth driver, provides ample opportunities for communication equipment manufacturers like Alcatel-Lucent to gain from potential contracts from adoption of this technology in China.
Looking at the upcoming 4G auctions in China, telecom providers have increased their infrastructure build up to capitalize on this 4G revolution. China Mobile, the largest mobile company in terms of subscriber base of 740 million, heads the race to grab this opportunity. The company had lost subscribers in the 3G segment to its competitors like China Telecom (CHA) and China Unicom (CHU), due to launching of 3G services in Time Division Synchronous Code Division Multiple Access, or TD-SCDMA, mode. This network mode has faced compatibility issues with smartphone manufactures like Apple (AAPL), that doesn't manufacture TD-SCDMA supported phones. Looking at these issues, China Mobile has opted to roll out its 4G services in Time-Division Long-Term Evolution, or TD-LTE, mode. This network mode is expected to be compatible with Apple's upcoming iPhone, which is expected to support both 3G and 4G networks in China thanks to Qualcomm's recently launched baseband processors, which are compatible with both networks.
The buzz towards this launch of compatible smartphones has been making headlines after news of a meeting between Apple's CEO and China Mobile's chairman regarding this launch. Apple, which is facing stiff competition from Samsung (OTC:SSNLF), is betting on China Mobile's huge subscriber base for growth of iPhone sales in China.
With 138 million China Mobile 3G users reported in June this year, even a 10% market share in this subscriber base would mean additional sales of 13.8 million iPhones, and this figure excludes the potential 4G market. Recently, Apple announced that its product launch event for its new iPhone will be held simultaneously in the U.S. and China. This announcement has made the case of a launch of a compatible iPhone stronger.
The recent talk with Apple and infrastructure build up will help China Mobile gain leadership in the 4G market. The company has already built 20,000 TD-LTE base stations in 15 cities for trials of 4G services, and plans to spread its presence to 100 cities by constructing 200,000 more base stations by end of 2013. All these investments are expected to bear fruit in terms of revenue growth with its market leadership in 4G market. This market is expected to have 439.9 million users in 2017 with China Mobile having s 52% share, as per market research firm IHS iSuppli.
On the other hand, Alcatel-Lucent is facing stiff competition in the communication equipment industry and is expecting more contracts after the 4G auction, which is expected to help in consolidation of its declining revenue.
We are taking Enterprise Value/EBITDA multiple for peer analysis of Alcatel-Lucent, as it is not conclusive to evaluate the company because of its negative bottom line and R&D commitments, which affect the expenditure side of its income statement.
After doing the peer analysis on the Enterprise Value/EBITDA multiple, we have found that Alcatel-Lucent currently trades at 6.22x for the trailing 12 months, which is lower than its biggest European rival Ericsson (ERIC), which has value of 8.11x for the trailing 12 month period. This comparison denotes that Alcatel-Lucent is undervalued as compared to its peer, and due to its initiatives, the company has upside potential that can benefit investors in the future.
China's mobile 4G revolution and new strategic partnership with Qualcomm are expected to lay foundation for Alcatel-Lucent's turnaround scenario. Despite its weak performance, investors have shown confidence towards the company's growth initiatives, which are reflected in the company's stock price that has appreciated 164% YTD.
Whether it's a buy or sell is not a clear cut answer for this stock, but one thing is for certain: under the leadership Michael Combes, the company has a turnaround plan in place to achieve targeted revenue growth as per its Shift Plan, which is expected to reflect in the company's bottom line. Investors must understand that this stock must be viewed as a long term investment. Turnaround doesn't happen overnight. Although Alcatel-Lucent is facing stiff competition from Chinese and European vendors, the company is building its R&D capabilities to cater to the growing demand for innovative products in the telecommunication industry.
Additional disclosure: Fusion Research is a team of equity analysts. This article was written by Rohit Gupta, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.