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Alcatel-Lucent (NYSE:ALU) is a global telecommunications equipment group that employs more than 70,000 people and operates in more than 130 countries. The company's core business consists of network hardware, Internet Protocol technologies and services.

The French group has kept making strategic errors over the last 15 years, which culminated with the merger with Lucent in 2006. The management decided for instance to sell Alstom (power generation and transportation) in 1998 or Nexans (copper and optical fibbers) in 2002, two entities that could have brought profits, perspectives and the possibility to be a universal telecom player against Chinese competition.

Alcatel's creativity, innovation and added value now rely exclusively on past acquisitions such as Bell Labs.

However the new management launched a three-year plan in order to refocus the group on its main and profitable activities such as IP technologies, routers and cloud and networks that account for 40% of the revenues. But also high speed networks especially in the US (Alcatel already has half of the 4G market) and in China.

The objective of this article was to determine the operating margin needed in order to generate positive free cash flow (FCF) at the end of the year, and to realize a DCF based on Alcatel's growth perspectives and restructuring costs, now that the management was able to provide more visibility to investors.

Growth perspectives

The increasing demand for wireless data should drive the telecom equipment market over the next few years. The market should be worth $217 billion worldwide in 2017 with strong growth drivers in Asia. According to Infonetics, service providers and enterprises will spend a cumulative $1 trillion on telecom and datacom equipment and software between now and 2017.

ALU should benefit from growing investments in 4G in Europe. The French group was chosen by Telefonica in September in order to develop 60% of the 4G network in Spain and recently won a deal with China Mobile to develop a part of the 4G network. According to analysts, China Mobile should spend more than $3.20 billion in the upcoming years to develop its network.

However, such a strategy will require heavy investments in R&D, which should impact the EBIT margin at medium term.

Alcatel's strategy is also geared to strengthening its position in the cloud industry, thanks to its internal startup Cloudband. According to Dor Skuler, Cloudband's CEO, virtual networks should allow telecom players to increase their network almost instantly when it now takes nine months. ALU could become a main player and generate added value and revenues, even if such a strategy will impact negatively its historical network equipment business.

The company has a strong presence in the US (46% of the revenues, +7% yoy, source: 2Q13 financial report) as well as in China and India. I believe that these countries will drive revenues over the next years until European countries start investing in 4G networks. I like the fact that Alcatel is not very exposed to Europe (24% of the revenues, -3% yoy, source: 2Q13 financial report).

Finally people always forget that ALU is one on the most innovative companies in the tech industry, mainly thanks to several subsidiaries such as Bell Labs. This year for instance, the French group ranked very well in the Reuters Top 100 Global Innovators.

Restructuring of the company

The group should sell about $1 billion of assets within the next three years and refocus R&D on IP technologies. Alcatel also announced 10,000 net job cuts last month, in line with the objective to reduce the cost structure by 20% ($1 billion).

It's also interesting to notice that business lines have been reorganized so that each one has now its own P&L and is responsible for its results. That was the company's structure before the merger with Lucent, which should bring more visibility to management and investors.

In the medium term, the management should increase debt maturities and reduce liabilities by approximately $2 billion. Other asset disposals could be set up over the next few years.

It's finally interesting to notice that the company is being restructured without losing the French government's trust. I believe that the government will support the management and the new plan (even though the ministers talk a lot), which could be an asset short term.

Operating margin

$m

2013E

Revenues

19,617

Revenues growth (%)

3

EBIT

1,177.043

EBIT margin (%)

6.0

D&A

1,177

% revenues

6.0

EBITDA

2,354

EBITDA margin (%)

12.0

Change in NWC

0

Capex

785

% revenues

4.0

Restructuring costs and others

1,569

% revenues

8

FCF

0

Hypothesis

Revenue growth: 3%

D&A margin: 6%

No change in NWC

Capex: 4%

Restructuring costs and others: 8%

The operating margin needed to generate positive FCF in 2013 should be about 6%, which seems to be very high regarding Alcatel's current performance (-27% and -7.5% EBIT margin for 1Q13 and 2Q13).

However, 3Q13 results should be watched carefully in order to see if the operating margin keeps improving but I don't believe that the Group will generate positive FCF before 2015. Someone that would consider investing in ALU should keep in mind that the company is still far from being profitable.

DCF

$m

2013E

2014E

2015E

2016E

2017E

Revenues

19,617

20,206

21,014

21,855

22,729

Revenues growth (%)

3

3

4

4

4

EBIT

-981

0

420

656

1,136

EBIT margin (%)

-5.0

0

2

3.0

5.0

D&A

1,177

1,212

1,261

1,311

1,364

% revenues

6.0

6.0

6.0

6.0

6.0

Change in NWC

0

0

0

0

0

Capex

785

808

841

874

909

% revenues

4.0

4.0

4.0

4.0

4.0

Restructuring costs and others

1,569

1,010

841

656

682

% revenues

8

5

4

3

3

FCF

-2,158

-606

0

437

909

Hypothesis

WACC (industry): 10%

Terminal growth: 2%

EBIT margin: 5%

EV

9992

Net debt

1032

Value of equity

8960

Nb of shares

2300

Price

3,91

I applied a conservative long term-EBIT margin of 5% in order to reflect the uncertainty regarding Alcatel's capacity to restructure its activities and reduce costs.

The valuation also reflects several weaknesses of the company that should impact negatively the results over the next few years, before the restructuring and specialization are completed:

  1. The increased competition with Chinese companies such as Huawei and ZTE makes the Asian market difficult to operate.
  2. The router market is also becoming more and more competitive considering competitors like Cisco (NASDAQ:CSCO) and Juniper (NYSE:JNPR).
  3. The European market is still slow.

Summary

The share price has already increased by more than 250% over the last year as management was able to provide more visibility about the strategy of the group. However I believe that the market takes into consideration future revenues and cash flows that are still far to come.

Moreover, a potential merger with Nokia could have a negative impact on the share price at medium term like it frequently happens in Telecom M&As, even if the share price could go up before the buyout. I also believe that the French Government is unlikely to let a merger happen.

As a consequence I'm neutral about the stock and believe that it is currently fairly valued. There is still a lot of uncertainty about the company - Michel Combes declared today that Alcatel could disappear...

Source: Is It Time To Stop Speculating On Alcatel-Lucent?