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Alcatel-Lucent (NYSE:ALU)

Q4 2009 Earnings Call

February 11, 2010 7:00 am ET

Executives

Ben Verwaayen - Managing Director (NYSE:CEO), Member of the Management Committee, Director

Paul J. Tufano - Chief Financial Officer, Member of the Management Committee

Peter - VP, IR

Analysts

John Stanovich (ph) - KPro Capital Markets (ph)

Adon Laport (ph) - Cheuvreux

Andrew Griffin - Bank of America/Merrill Lynch

Sharif Bakra (ph) - Citi

Unidentified Analyst - Reuters

Amit Kristnen (ph) - UBS

Vas Amadae (ph) - Modo (ph)

Sam Kovinda (ph) - Credit Suisse

Unidentified Analyst

Alexander Peterc - Exane BNP Paribas

Tim Boddy - Goldman Sachs

Simon Leopold - Morgan Keegan

Ben Verwaayen

Thank you very much for joining us. Whether you’re here or on the webcast, thank you for joining us I really appreciate it. Today we’re going to talk about our Q4 results and we’re going to talk about the full year.

So first I’ll introduce you to one of your favorite slides, I am pretty sure that you will give full attention to that, because our lawyers are working very hard on that every single time and find the difference is probably what I would like to challenge you. But we’re not going to do it right now.

So, one of the most important things that a company has to offer is credibility and everybody who’s ever been on a board is looking to that and saying, make sure that you’re credible. Make sure that you deliver what you promise, because there is nothing more important for a company than to be consistent in what you say you’re going to do and what you actually do, and I think we have done that in 2009.

So let’s go back 12 months where we were, what were the concerns of the market? What was the market saying to us? Well the market was saying to us, basically, three things. Are you credible for your customers? Are you addressing really the issues that your customers worry about? And are you then capable of delivering that and benefiting from that?

The second thing the market was saying was, look to your balance sheet. Make sure that you deliver a stronger balance sheet at the end of the year than at the beginning of the year, because that’s what the market will want to know and that’s what your customers want to know.

And a third thing the market said is, are you able to transform yourself? Are you taking the hard decisions and executing on them? And my message to you today is, we’ve done all of that.

Yesterday, was an important day for us, we won the AT&T account. It’s not just the business as such, but the nature of the business that is truly important to understand. Because to be honest to you, 18 months ago it wasn’t a foregone conclusion that we would be able from a technical and a strategic point of view to deliver that type of capability of transformation.

It is something that is much more than the next box. It’s the ability to include different approach and applications and business model, to deliver. And it opens a whole new world of capabilities that we are able and capable of delivering, which wasn’t the case 18 months ago.

So on that basis and on the three points that I just gave to you, it’s important to look to the results that we have presented to you today. First of all, we have delivered the operating income, actually this quarter was good, because this quarter was a profitable quarter, both on the operating level as on the net level. It’s important to note that.

The second thing was we have to do work, cost management, and we promised $750 million, we delivered $950 million, that’s a 28% increase and it’s important because it is across the business. 40% of that is in COGS and I salute the team that really went very hard and went after that step-by-step to deliver that.

35% was in SG&A and you know that SG&A is one of those elements in costs that keep growing whatever you do, so you need good true cost management to get it done and the team did a great job. And 25% on R&D, most of that is in what I would say is making the hard choices and sticking to them. Making sure that you choose to let your Euros, Dollars, Yens, whatever, work in that area where you can make a difference for your customers.

So if you looked to the cost reduction on one side in the R&D field you have to look to the other side of the equation and that is, where do we build winning platforms with the same vigor as you go and reduce the exposure that you have in your organization? Maybe because you have a multiple of platforms that you want to eliminate, or look to what is more a harvesting part of the market than a (inaudible) part of the market.

And I think with taking those hard decisions, not only taking the decisions we’ve executed and that’s why we have with this type of cost savings, and now you look to the Q4 exit run-rate, a tremendous, good, starting momentum for 2010. I think we have demonstrated our ability to generate cash, $635 million operating cash for the quarter, translating it to $173 million free cash flow is a tremendous achievement. It is something that we hoped to aspire and we did. We did execute it, which is something a little bit remote from aspiration.

Then we strengthened our balance sheet, we have today $5.6 billion in marketable securities in cash, which is a billion better than where we were a year ago and in the meantime we paid off some debt. So if you take that equation it is clear that we have said yes to the market demand that said, look to your balance sheet and make it better.

The last point I want to say is relevance to our customers, it is probably the most important thing. The world is changing and if we have called a market down 8%-12% this year and fortunately we were right. And we called the market for next year up 0%-5%, and I’m convinced that we’re right as well.

And what is the difference between the two? Not always, of course, 0%-5% on a lower platform because of the 8%-12% which turned out to be, in our case, 12 and a little bit. But the most important thing is that the drive to change, and I will come to that in a minute, are here to stay because they are fundamental changes in the business models of our customs.

To be relevant there means that you have to look to, not just how much is your revenue, but more important where is your revenue? Where does it hit the customer? And in what part of the model are you? And it is clear that we predict that in 2010 the same selectivity in the old technology will take place as it was in 2009, nothing will change there. We will not see a very sudden build out of footprint waiting for customers to happen as we’ve seen in 2006 and 2007, it will be selective. But where it won’t be selective is where they can make a difference. So the question is do you have the portfolio to address those parts of the market where you can make a difference?

So, I think we have gained a position of trust with many of our customers. Verizon and AT&T is a clear indication of the U.S. market on mobility and LTE, without going too much into detail, is not just the next generation mobility, it is a different model of dealing with mobile internet. It’s the PC in the palm of your hand, which is a very different set of criteria and needs that you need for networks, that you need for capacity play but more important in the differentiation of applications that you offer to the market. If you want to monetize that as a service provider you have to think very much out of the box.

I think we are delivering that capability which means a transformation capability to our customers, and since it goes very in the heart of what our customers do, you need to be a trusted partner; a vendor per se won’t do the job.

Second, it’s important to see that if you look through the composition of networks without being too technical, that the layer of which you do the transport really matters because the lowest cost of transport will be a very important part of the model going forward. And the ability that we have with optical and IP now working together hand-in-hand and creating that layer capability, first order was with Quest, I can see a pipeline that is very interesting there.

It will be a pipeline that looks to capacity, like 100G and it looks also to the capacity to play with the various layers in the network to get a real optimization of a very different pattern in traffic, basically dominated by the new video type of network capacity that’s needed in the models.

The next point is if you look to applications, it is the ability to make choices, it is not just one application that will make the difference, it is do you give the size and capability to service providers to deliver, to differentiate? One service provider may have a very different model than the other.

We talked about the over-the-top for quite some time. But I can tell you application enablement this year, not only was it churning from a loss making business into a positive contributor to our business, which is phenomenal. Some of the growth that you see in some of the pockets are more than 100% growth.

So you see, for example in Motive, which is a remote customer care capability, customer management capability, all of a sudden it’s not just a tool to do things that I always have to do and I do it a little bit cheaper. It is I can now do very different things with my customers that I couldn’t do before, so that it is a massive difference that you will see going forward. I think that the way we managed to stop certain areas, more the old fashioned stuff, which we have a one-time of with many of our customers, and go to platform capabilities here will pay off in the future, it is a very important part.

Now one of the important markets also, of course, is China and the migration from 2G to 3G, in China has been, I would say, very well planned. And one of the things that we then saw in China was that there was a handset issue with the various standards. I think you will see that they very skillfully have managed that to create more demand from the supply market to go to China as well and I think that you will see that not only did we increase our market share from 2G to 3G you also see that 3G to 4G will go faster than we have seen in the past. But you also see that their 3G growth in 2010 will be better than what we saw earlier because they solved that issue around the handset capability, that’s important.

And last but not least, if you look to our services, you see that we win contracts in a variety of services. It’s not just maintenance, it’s not just managed services, it’s also integration and very important multi-vendor maintenance, as a kind of capability for service providers to do something with their fixed cost and to do something about where they focus their best people and where not.

Now if you look to the total number in Q4 you could say that was a not so fantastic growth number, but if you look underneath that you can see that there where they could make a difference for the business models that they used, we’ve done very well. And you will see in the press release some of the details about where we did well and where we did a little bit less.

The interesting thing here to note is that managed services is growing very well in markets where labor arbitrage is probably not the reason why we do very well there, because you look to India that is not the most likely reason to be very effective. So it is the more added skills that we have in there and I think that the services are more and more aligned with the rest of our strategy that is really focused on the differentiation. That’s a good part of why we’re winning.

Now, what type of products do we have? More and more our products are not stand-alone products, they are not the box that can do a nice trick, it’s the solution, it’s the getting things together that make a difference for the way our customers have to deal with their changing environment. And their changing environment is the video in the palm of your hands, the capability of an IP all-over network that needs to be in a transformational mode, meaning that it should lower not just our cost it should increase the flexibility and the capability they have, to do much better for their customers.

And I think we are building a pipeline that is truly answering that demand. And I’m very optimistic that continuing along those lines we will shift away from the ‘me too’ type of products, where to be honest price is the only differentiator, to a market where we differentiate on the capabilities that we bring into the hands of our customers. And that requires a different style in our own organization and I think we have turned that corner in 2009. How you develop products, how you work together with the capabilities and you bring to market things that really matter.

So for example, if you look to what we have called a software defined radio, basically it says you have a module and whether you want it to be 2G, 3G or 4G, all the capabilities are in that module, you can switch without doing anything. So you can react much faster to what happens in the network itself. If you look to transport well the big issue is, we have an all you can eat package in this world.

We assume that you would stay with McDonalds, now you turn to a three star (inaudible) restaurant, the cost price is very different, that’s the difference between voice and video, but we promised an all you can eat package. How are we going to differentiate from that? How are we going to entice you to have a feeling, the perception of real value that you get? You need to develop that. You need to develop that not by saying, oops, I really don’t want an all you can eat package, but by giving perceived value to new services that customers are willing to pay for. And we have the capability to bring that into the domain of our service providers to make the difference.

And at the same time some of these products are perfectly suited to deal with issues like Smart-Grid, so you’re not just expanding on your value added within the service providers market, we are also expanded the market that we conserve.

So yes, Q4 revenues were not what we hoped for, that’s sure. I think if you look and dig deep what is the reason for that, you’ll find four reasons. First of all, I do not want to sound offensive at all, it was not the number that we hoped for, but it hasn’t changed our capability to absolutely fundamentally reform every line but the top line in Q4. Now, in Q4 if you look to our top line there are four reasons that we have identified that made it less than what we hoped for.

If you look to Q3 we were down something like 11% year-over-year, and when you end Q4 you are just over 12%, that’s not what you want. And the reason for that is basically four items that we have identified here. The first one is that China is to build out its 3G, very strong Q4 in 2008, the plan was always a plan between November and November, so to say, the build-out is done, so it is a kind of slow season on 3G, it has been in Q4. We’ll see what 2010 will do, but I think I gave some indication when I talked about the availability of the handsets.

The second point is that if you look to the U.S. we had a certification of the RNC, which was one of our biggest customers in Q3, which meant that we could take a very strong Q3 in the U.S. Q4 was more normalized from that point of view so there was some sequential effect.

We walked away from a few models, I have to say, if a sales team comes in and says to Paul and myself, we’re going to walk, I applaud them, if they walk for the right reason of course. If they walk because they couldn’t meet the criteria, that’s a bad thing. If they walk because they think that from a risk perspective, from a cash perspective, we can better utilize our resource, that’s a good thing. We did that.

And we had specific supply chain issues with some of our specialized components in Q4. Things happen, one of the things that you will see later one when we talk about improvement capabilities that we have going forward, certainly supply chain is one of them and we are working very hard on doing that. That was the Q4 top-line message, strategically I would say, this was not on the warrior list, from a strategic point of view, from an operation point of view, yes, from a strategic point of view, not. So we didn’t lose business here as going to somebody else, and that we couldn’t serve.

So operational progress, this has been phenomenal, I can talk all day about what we did in 2009 from an operational perspective and again go back 12 months see what our company was and what we are now, it is a massive difference. This is a different company, it’s a company that is building a platform to achieve our goals and we have set our goals for 2011 very clearly and I think we are building that platform, in order to do that you need to do a few things. Operationally, much better than what we did before and I think one of the four things to look at is the operation margin.

What do we do with margins? Well we have four elements in the margins. We talked about walking away, so you are selective on your contracts. It is important to do that, to have the confidence to do that. And of course, you have to then reduce your operation costs, we did, you have to do better with procurements, we did. And thanks to the team for doing that because it’s a tough market to go and do that.

And then you need of course, to design for cost, so it’s also an R&D matter, if you want to have a product that is capable of competing in the market, it’s very important that you understand the market not just from a technical perspective but also from a cost perspective. And one of the things that I really don’t like is the text, we are going to cost reduce a product, you’re too late, you have to design for cost. And I think you can see our (inaudible) in the process of actually doing that in the requirements is the cost point, one of the most important things from the get-go, which is a very important element to it.

So, a margin (inaudible) the years. Second, expense management, we talked about it $750 million a year to $950 million, that’s good, because it gives you a run-rate exit for Q4 that gives you’re a very fair chance in 2010 to even better. So that is very positive and it is across the board.

Third element, the profitability of the bottom line. Yes, some people say yeah, but you sold motors, that's part of it. Sure, so part of it use all the leverage you have in the organization, look to where your assets are, which assets you want to make work for you, how do you make sure that you're well positioned and you invest in those areas where you can make a difference and keep making the difference in the market? So I think it is a totally legitimate part, and by the way it was one of the things we said we would do, and as I said at the beginning, we execute on what we say we do.

So on the last part, if you look to the working capital, a great improvement on two elements that I would like to highlight. First one is collection, over dues. We have halved it in 12 months time. That is a really good performance. And on the inventory we have taken a very strict policy on inventory. Maybe some people will say I can see that also a little bit in the top line ,but let me tell you, it is a good thing to do. It's a good thing to do because it gives the discipline and the capability for an organization to really deal with it.

And then all of that translates into cash. So if you look to our net cash position of almost $900 million and you compare that with a year ago, that was -400. So it's a swing of $1.3 billion. I would call that a credible swing.

So where are we now? Let's talk about — oh, I go the wrong way. So we go the other way. Where are we now? I think 2010 will see growth and it's driven by three elements. First of all, and let's start with that, you will see that hundreds of millions of people that were not connected to networks today will be in the coming 12 months. They come on board in India and in China and all the emerging markets, and they join us and they will use it not as we started to use it in the mature markets, but they'll use it right away in the same type of activity as you see all of us doing.

So they don't start with the previous technologies and go through all the steps. They step in and they step in at our level, immediately. And hundreds of millions will add, which means emerging market is for us a growth market and opportunity market. The second thing that is equally important in that is how people use communications. It is becoming an ingredient of all our business models. If you look to health care, all of a sudden you'll see that telecommunications is a part of the solution how to get there. If you look to energy you will see with smart grids and other stuff, it's a part of how to get there. So the addressable market is going up and it is because of IP and the IP transformation that you can go across a much wider field than what you have seen before.

And last but not least, it is the phenomena of the smart phone in whatever shape or form, whether you want to read a book, whether you want to play a game, whether you want to do video, whatever you want it changes the dynamics of networks and therefore the addressable market. I think this market will grow in the selective areas, not across the board, not with every product so it matters what type of product and service you have to offer, and I think we have the right capabilities.

Now, how do we profit from that? Here are the four elements; the first thing is differentiation. We are not going to be a me too company. We're going to do things different and we will get a reward for being different. We will be passionate with our customers, close to our customers with the capability as we have now demonstrated to make a difference for them, and that means that you have your products in a very different framework than just a point product. So differentiation is the first important element of your capacity and capability to really make a difference for your customers.

The second one is the addressable market. And I said that before, we sold to service providers — well, you can question whether how wide the world of service providers is now diverging into very different business models, and in addition to that our relationship with HP for example gives us access to markets that were close to us up until recent and we're co designing together with HP on our series of solution to the marketplace and I think you will see the impact starting in 2010 so that's a very important one.

And of course we have our blocking and tackling, and the blocking and tackling is about the expenses and I'm sure that Paul will say a few words about it, and last but not least is the way we execute. Our execution gives us a lot of new opportunities going forward.

So if I bring that all together, and the first thing I say to you in this room, the end of 2008 when we first talked I said to you this is a road to the end of 2011. On that word, on that promise, I think the year 2009 is best called a tick in the box. Paul?

Paul J. Tufano

Okay. Thank you, Ben. What I will do today is provide some color around the financials and build on some of the points that Ben articulated. Clearly 2009 I think was a year of solid performance and we did meet our commitments and it does set the base for the journey for the next two years. Clearly, in the bottom line we achieved our adjusted breakeven profit and a very strong Q4 of $271 million despite the softness in some of the revenue, and that was really done by the work in reducing the cost of the expense structure and some of the overachievement.

What I want to point out to you is the margin profile of the company in the fourth quarter. We had operating margins of about 6.8% and we had gross margins of 36.7 which are the highest we've had in almost two years and I think are an indication of the leverage of the cost reduction when you have revenue growth. I won't spend any time talking about the revenue. Ben's gone through that. At constant currency we were down about 12.4% for the full year, slightly above the range we gave. But I'll spend some time talking about the margin expansion, especially the growth margins. Now obviously in the fourth quarter on a year on year basis you can see that we are three points, four points, above 2008. And if you remember correctly, in 2008 we had a one-time charge that was about 50 basis points. When we adjust for that it's about 2.9, still a pretty good improvement year on year.

A third of that 2.9 improvement came from better selectivity of contracts and discipline with regard to business we went after and the business we accept. The other two thirds is a result of the cost reductions that have been ongoing throughout the course of the year both in the materials are in terms of component negotiation as well as reducing our fixed cost structure throughout the company.

If you look at the third quarter to the fourth quarter you can see a similar 3% increase, slightly more than 3% — the entirety of that was cost reduction. As we got the increasing revenue, the cost of the fixed costs actually went down. You saw an accelerator effect of the bottom line and obviously that's what we want to build up as we move through 2010.

From the expense standpoint, you can see on the charts the reduction in the expense as it was calculated and we've talked about the $750 million. I want to remind you how we calculate the 750. $750 million is an exit run rate of the fourth quarter of '09 versus the fourth quarter of '08 on a variety of elements, so it's an exit run rate basis. We did overachieve that by about a little over 28% and that was good performance across the board in every area.

Now obviously some of the actions we've taken in the fourth quarter will have implications as we move through 2010 in terms of continued savings. If we now turn to revenue by operating segments, here you can see the constant currency adjustments. We were down about 12.4% as I said for the year, about 17% in the quarter. And if you look at the trend underneath these segments, it is the continuation of what we've seen all year and is a reflection of the points Ben made in his speech. In those areas where we can help our customers transform to change their businesses, we see growth.

And so, during the course of the fourth quarter as we saw through the entirety of 2009, we saw good growth in IP service edge routers. We saw growth in WCDMA. We saw growth in submarine, all in the carrier spaces. In the legacy products; GSM, CDMA, that wasn't the case. Parts of terrestrial optics — and so where we can differentiate we win.

In applications we saw good growth both of the year as well as for the quarter at almost a little over 5%. I think this is indicative of the applications we're bringing to the table; motive, our professional services, digital media, advertising, and we saw growth in services though it was tempered by the fact that our maintenance business which is a large amount, grew at a nominal rate which tampered down the positive effects of MOD and NSI. But again, reinforcement that the strategy we are implementing I think is being reflected in the buying patterns of our customers.

If we turn to operating segments, the point I leave you with here is the cost and expense reductions are taking hold in every segment. We see each segment profitable this quarter. They were not all profitable last quarter. Carrier, for example, was at -$27 million in last quarter in net income and it's now turned to $19 million. It shows the power of revenue growth with cost reduction and the leverage in the bottom line.

Applications for the full year, $65 million. That was breakeven in the third quarter. Again, good growth. The application area, they are focusing on their core products, they are holding their expense structure, and it is benefiting. And you can see that services continue to contribute at about the same level; good growth from the fourth quarter of last year and even more growth in the third quarter. So I think as we continue our focus on cost and expense reduction, on putting our R&D investment on growth products, and differentiation, you'll see dramatic changes by profitability for the year and by segment.

Turning to revenue, if you look at our overall distribution of revenue it's unchanged. Approximately two-thirds of our revenue comes from America and from Europe, the rest from the rest of the world. Now during the course of the year we have seen different patterns of geographies. In Europe, for example, we started the year very strong and as headwinds happened in the second half you can see the year-on-year reduction of 15%. But Europe showed good sequential growth in the fourth quarter.

In America, obviously we started weaker, we ended stronger. Quarter on quarter, third versus fourth quarter, there was some redistribution with regard to revenue recognized based on certification of that certain product. In Asia Pacific the entire story is around China. Last year in the fourth quarter China had a very strong quarter with CDMA volume, and the first half of this year was 3G license. They're now pausing to digest that, so you can see a different trend.

And the rest of the world it's primarily Latin America and South America which we've seen probably the biggest erosion primarily driven by currency and lack of credit. Middle East and Africa has fared much better, so a different composite by each of the geographies. I think as we go into 2010 you'll see different recovery paths by each.

Turning to the balance sheet, if I can say one word on the balance sheet it is working capital. As we've been indicated from a working capital standpoint you can see we reduced overall working capital by 177 million euros. That contributed to the net cash gain of 294 coupled with the sales of Telus.

For a full year, the point I'd make to you this year is the goodwill line is unchanged. That means there is no impairment, and if you remember correctly, we've had impairments of several billion euros over the last several years so we're happy to say that we executed our plan and therefore it didn't result in an impairment.

Turning to operating capital, we've always said that what you can do with your operating working capital is (inaudible) in a company. Those companies that have discipline generate cash. I think we can say that we're beginning to get that discipline. You can see from this chart that we've had reductions in inventory dramatically both in the quarter and for the full year. For the full year those reductions were almost 500 million euro, but more importantly, we increased the overall turnover by one full turn year on year and we reduced our days inventory outstanding by five days.

From receivables, slight growth in the quarter given the revenue, but over 1 billion euros of receivable in reduction year on year. Sixteen days reduction in days sales outstanding, a lot of that driven by collection of overdue. Now as we said before to a lot of you in individual meetings and on our road trips, over dues was a critical metric for us in terms of will we attack a problem with discipline. I think we've demonstrated that we have the will and the capability to do that and there's more to be had in 2010. And from a payable standpoint, obviously a slight increase in payables, but the payable days outstanding was an 11 day decrease. So net, almost 10 days of cash conversion cycle improvement year on year the bulk of which came in the second half of the year.

So my hat's off to the team. I think they did a good job and this is reflective to the discipline that's in the organization. From a cash flow standpoint, obviously you want to look to the free cash flow line, $173 million. I guess the thing that I'm heartened by is the fact that this is the second consecutive quarter of free cash flow and normally the company has free cash flow in the fourth quarter so we've been able to generate cash flow in both the fourth as well as the third and that was driven by the very strong operating cash flow of which the working capital is a big contributor, but it's good discipline.

The other thing to note is we held to our estimates and all the other lines in the cash flow statement; restructuring came in at $560 million which is slightly below the $600 million we guided out to. Our contributions to pension were at $226 million. That's right in the middle of the range we had told you. And our CapEx is slightly below the $700 million we outlined. So it's not really working capital discipline, it's also discipline in ensuring that we manage those other lines as well and that's important. And the result is a net change in cash of $294 million.

During the course of the quarter we did repurchase about 172 million of the July put in the (inaudible) for January, and our revolving credit facility remains undrawn with all covenants met.

From a pension standpoint, from an accounting view you can see a slight improvement in the pension. The funded status actually improved and that's because the asset values went up in the fourth quarter because the discount rate slightly improved you see our liabilities went down. As we look at potential funding from an ERISA standpoint in the United States, our preliminary assessment is that we will not see any funding through at least 2011 and so I think pensions are also off the table.

So now as we turn to 2010, if you look at the preamble on our press release you can see that we believe the economic environment globally is stabilizing. As Ben indicated, it's our belief that the telecommunications market and related sectors will grow at a nominal rate and we've defined that as 0%-5%, and we believe we're very well positioned given our customer engagements, the retooling of our product portfolio, the actions we've taken on cost and expense structure, to benefit in 2010.

Now over a year ago we gave you guidance for 2009 and we gave you our aspirations for 2010 and '11. We're now going to turn to 2010 aspirations and guidance. So given where we are in the year with some uncertainty, we're being a little prudent, and I want to emphasize a little in that we're opening the range slightly to mid-single digits to low-single digits. But our goal for 2010 remains unchanged, our aspiration. And we know that successful 2010 is instrumental to getting to where we need to be so we will do everything we can to drive to the highest level of that range possible.

With that, I'll turn it over to Ben and we can have a Q&A.

Question-and-Answer Session

Ben Verwaayen

Right. So we have questions here in the room and probably also, Peter, so you take it from here.

Peter

Yes, thank you. I'll ask the operator to give instructions for the audio bridge, please.

Operator

(Operator's Instructions).

Peter

Okay. We'll take the first question from the room.

John Stanovich - KPro Capital Markets

Yeah, hello. John Stanovich (ph) with KPro Capital Markets (ph) in Paris. I've got one question regarding seasonality for 2010. Could you please give us some color on seasonality for the first quarter?

Paul J. Tufano

Well look, obviously the first quarter usually is seasonally weak. We think that perhaps we can do a little better than perhaps what has been in store, right? We had a pretty good order book in the fourth quarter, now it's a question of converting that.

Ben Verwaayen

Yeah. I think if you look to Q4 we had quite some success in the order book. It is also very important to see that some of the old seasonality that was historically in the buildup had to do with you build up for Q4 and everybody takes a breather. I don't think that we're taking a breather so if you work in (inaudible) I don't think that anybody will accuse us that we have a breather in the first couple of weeks or in the first month. So I think that I echo what Paul just said. There is some of that seasonality, but I think we should be able to do a little bit better.

Adon Laport - Cheuvreux

Yes, thank you. This is Adon Laport (ph) with Cheuvreux. Could you talk a little bit about the 99 wireless network guardian you run with AT&T? Is that big in terms of sales?

Ben Verwaayen

So one of the privileges of customers is that they decide where they spend and how much they spend with whom. So the press release was clear, it selected ourselves and Ericsson on LTE. The model is 40-4020 which means you get both 40% and 20% is up for the best performer which is, I think, a great incentive to go and do. We have more of those contracts in the business and so far I would say that we are a big fan of that model for obvious reasons.

The spend, I'm not going to comment on that, but I'm going to comment a little bit about the significance because as I said 18 months ago, where were we? We had a joint venture with another company in Japan and it was very clear where we were. Eighteen months later we have 40 trials. Today we will announce another win here in France on a very significant trial with SFR.

Male Speaker

It's already up.

Ben Verwaayen

It's already up. So today we have announced, thank you for changing my language here. So today we have announced that. You can see that we have really gained traction, and importantly enough, it also opens a lot of doors to go into the IP domain. We have 11, as we called, evolve packet core trials around the world and you can see that it is so much more than simply the next generation of mobility. It has a substantial significance. Now, contracts like an LTE contract are long-term contracts. You build over years and I think it is very significant also to be part, if you look to the AT&T contract, of their network management part with the guardian project which means that you give a capability to the network to react much better to the flows of the traffic.

You have much better capability to go to the management layer. And on top of that I think we are officially part of the mobility domain in AT&T which is also very important, because as you know they have now divided their purchases into their own domains. So all in all a very significant win for us. We worked really, really hard. The competition was extraordinary and to come out on top is really great.

Peter

We'll take a call from the bridge please.

Operator

Thank you. We have a call from Andrew Griffon (ph). Please state your company name followed by your question.

Andrew Griffin - Bank of America/Merrill Lynch

Hi. I'm with Bank of America/Merrill Lynch. (Inaudible).

Ben Verwaayen

So this is very difficult to hear.

Andrew Griffin - Bank of America/Merrill Lynch

I'm sorry, can you hear me a bit better now?

Ben Verwaayen

Now it's a lot better.

Andrew Griffin - Bank of America/Merrill Lynch

Damn Cisco phones (laughter).

Ben Verwaayen

It could happen to the best.

Andrew Griffin - Bank of America/Merrill Lynch

Could you talk in a bit more detail about the linearity of cost cutting in 2009? In other words, what will the impact of a full year of those cost cutting in 2010 compared to 2009? And then also, what is the restructuring focus for 2010 in terms of a bit more specifics on the actions you're taking or are able to take and also financially in terms of the charges, cash outflows, and potential benefits of the 2010 actions?

Paul J. Tufano

Okay. If you look at the progression of cost reduction over 2009, as we said before it really started very slowly in the first half and accelerated in the second, and so there's a fair amount that will flow into the 2010 year. So I think that will help us.

Now, from a restructuring standpoint, we already have a lot of the actions under way, they're already implemented. So I think it's just executing what we have, and a lot of what is being addressed are those areas that are driving complexity out of the business through putting greater process simplification into the company, getting more harmonized processes, reducing redundancy, and primarily the back office areas. And so I think that will be the progression.

From a restructuring standpoint we spent 560 million euros this year cash restructuring. I think next year would be somewhere around that, maybe slightly higher, but probably no more than the 600 million we gave you guidance on last year.

Andrew Griffin - Bank of America/Merrill Lynch

And the benefits of that, you gave a figure last year of the 750 million target, is there a similar figure for the 2010?

Paul J. Tufano

Well, 750 was an exit run rate so I don't want to give an exit run rate again. I'd say in absolute euro term it's a number that will be in the over 300-400 million euro.

Andrew Griffin - Bank of America/Merrill Lynch

Okay. Thank you very much.

Peter

We'll take a question from the room.

Caroline Trakes - Tradition Securities

Yes. Caroline Trakes (ph) from Tradition Securities. Just a quick question, I would like to understand, you revise your guidance for 2010, but not for 2011. Is it due to a gap in your backlog?

Ben Verwaayen

So maybe misunderstandings are needed to be clarified. We have not changed our guidance for 2010. We had no guidance for 2010. We had a goal for 2010 and guidance is something very different. Guidance, from a legal or financial economic point of view, is what I said in the beginning, your credibility's at stake. So the goal is something you try to aspire to. Guidance is something that you will, at the end of the day, come and say to us this is what your guidance was. So it's a very different thing.

We have widened it somewhat, and as Paul said, we haven't shied away from what we aspire to achieve, but we give you some more certainty about the widening of the guidance that we now give because it's now guidance and we take that very seriously. We take that very seriously.

I think our backlog is very, very strong. I think if you see where we can make a difference in the portfolio in the channel, it's very, very strong. We are in a transformation process as a company and I think it is prudent when you talk about guidance to be a little bit more cautious and I'm not ashamed of being more cautious when it comes to the guidance. And for 2011, which is the aspiration where we go to what I baptized a normal company, that's a company that wins, a company that is willing to have a fair reward for shareholders and a fair reward for employees and a fair reward for our customers. Nothing we have said today should give you any impression that we shy away from that, and I think we are on the trajectory. That's what I said, 2009, tick in the box.

Now, some people get very upset about a number in a particular quarter. I don't think that if you take the line — we have never said it will be a smooth line and everything, but said it will be always a little bit like this, but the direction, directionally everything, the arrows are in the right direction.

Having said that, when we go about guidance we take a somewhat more cautious position.

Peter

We'll take a question from the bridge please.

Operator

Thank you. The next question comes from Sharif Bakra (ph). Please state your company name followed by your question .

Sharif Bakra - Citi

Yes, thank you. It's Sharif Bakra from Citi. Ben and Paul, you've talked a lot about your confidence heading into 2010 and seeing some form of market recovery. Ben, you've alluded to sort of improvements in your mix if I understood you correctly heading into 2010 in terms of where you're strategically focused. Paul, you've talked a lot about your lower cost base and how that will be carried through into 2010. Can you maybe help us understand how that reflects in your gross margin expectations for 2010 which is something that you alluded to, I think when you first started, Ben, but haven't referred to in terms of your most recent guidance. And perhaps if you'll just followup in terms of the 1%-5% which is obviously quite a broad range. Can you perhaps give us a sense, to the midpoint of that, what type of scenarios you're factoring in, in terms of pricing condition, particularly with some upcoming tenders or some recent aggression from some of the Chinese vendors?

Paul J. Tufano

Let me take the question on the gross margin. We talked about gross margins of mid thirties to slightly above the mid thirties. Clearly if you look at the fourth quarter at the 36 level, that' sin the range we would like to be in. Now in the fourth quarter we saw good revenue growth and the fact that we held our costs, it allowed us to fill out the bottom line.

As we go into 2010, the focus of the company is squarely on cost of goods sold reduction through product design and through cost of materials in those products. Because if we believe we can aggressively attack that like we did the fixed cost and expense structure, that will give us head room against market dynamics, whatever they might be. And so that's the goal for us going into 2010. I think 36, the number we posted in the fourth quarter, is a little rich, and I wouldn't expect that to be there throughout the entirety of 2010, but we're going to do everything we can to drive down the cost of goods sold number to make it as high as it can be.

Ben Verwaayen

So we had an average this year of 33. I think that you should take into account that we do better next year on that. When you talk about pricing, the aggressiveness in pricing, it's not necessarily true that it's always the Chinese to be honest. I mean, there's no exclusive right for the Chinese to be aggressive on pricing. Pricing aggressiveness, I don't think at the end of the day is going to save the day for anyone. It will be the differentiation that you bring to the product and you bring to the solution. So if you look to our strategy, our strategy is that we take into account a certain price erosion into the market and we try to outmaneuver that by more savings in our COGS as Paul was talking about, but we certainly will not be the driver of it. And I think we have no reason to be the driver of it because we find space, more and more space, in areas where we bring so much value to our customers that they see a reasonable basis for the prices that we have.

Now, not in every area you are able to have that luxury to have your full margin structure so you will have to make some choices there, but as you have seen we've done in 2009, if we don't think it makes sense then we don't do it. And I still feel extraordinarily comfortable that we have teams now in place that are close enough to our customers to make that distinction, to understand that, and to be early warners going back to us to talk about it which means that we have the opportunity to make choices and that gives a better feel than if you don't. I can assure you about that.

Peter

Okay. We'll take a question from the room, but I'd like to first ask that everyone limit their questions to one question as we have quite a queue.

Unidentified Analyst - Reuters

Hello. Just wanted to ask a question sort of about the broader market. Your competitors so far have not — I'm sorry, I'm from Reuters. Your competitors have not guided for this year really on what they think the market's going to do so you guys are a little bit out there on your own. Why are you maybe more optimistic than they are or what are you seeing that they are not?

Ben Verwaayen

So I'm not so sure that we're more optimistic than not, but we have taken a course of transparency. When we joined, we joined in a situation that was let's say less than desirable and we have made some promises to you, and one of the promises was that we will be clear about the roadmap ahead of us and we will be brutally honest with you.

So is there a temptation not to give guidance like everybody else? Yeah of course, on the safe side you wouldn't have some of the headlines that we got today, but I don't think it's fair for us. Where we are, we are in a transformation mode. I think you are entitled from us to know all the way every step in the way where we are and how we're doing things.

Now, by the time we have reached 2011 and we have earned ourselves to be let's say as I used to cal it, a normal company, who knows? But today, I think you're on the journey with us so you need to know where we are, and we have done our homework, I think, in 2009. I think we've done the same type of homework in 2010.

Unidentified Analyst - Reuters

(Inaudible)?

Ben Verwaayen

No. I think we're realistic.

Peter

We'll take a call from the bridge, please.

Operator

Thank you. Your next question comes from Amit Kristnen (ph). Please state your company name followed by your question.

Amit Kristnen - UBS

Yes, hi. Amit Kristnen from UBS. Thanks for taking my question. On the WCDMA side of the business, just wondering if you can update us in terms of the historical guidance you've had of achieving breakeven this year? And also, what will be the sort of long-term intention on this business? Is this something that you're looking to harvest for cash going forward or you want to grow market share and feel that an installed base is essential over here to grow, and in particularly in Europe?

Ben Verwaayen

So the whole 3G is a very interesting part. If you look, let's say five years out, you will see that even five years out, 3G will be an important part of the spend. So for us it is clearly an issue where we're going to differentiate, and there are many, many things that we have learned over the last 12 months. It's not so much that everybody will come out with the same approach to the market. We clearly are focusing on the differentiation that the whole video and data market will give to the client base, so that means that we will make sure that our products are, so to speak, forward compatible with what the 4G generation will be.

I think that you will see that we are investing in an area, differentiating in an area, taking issues like energy consumption and green as very, very close to our heart and also have the capability to make it a seamless transformation into LTE is clearly into our advantage. Having said that, 2009 I think we grow year over year something like 33% and we were, I would say, close to the breakeven thing that we said we would be.

Peter

Great. We'll take a question from the room.

Vas Amadae - Modo

Great. Vas Amadae (ph) from Modo (ph). Just to followup on your guidance for the markets in 2010. Three months ago you already talked about normative growth, 0%-5%, you stick to this large bracket despite encouraging signals seen by US operators in CapEx? So I suppose in parallel you see some deterioration, so despite China where are you seeing a deterioration?

Ben Verwaayen

So what's the benefit of narrowing your guidance? I mean, it's not a science on the market. I think 0%-5% is a respectable range, but you understand where the market is going. As your colleague said, we're the only ones who are coming out with it and I think this is what it is. And do not read tea leaves. It's not because you see something positive there that it must be something negative somewhere else. It is the range that's important and this is the range we feel comfortable with.

Peter

Another question from the bridge please.

Operator

Thank you. Karl Puntagasha (ph), please state your company name followed by your question.

Sam Kovinda - Credit Suisse

Hi, it's Sam Kovinda (ph) from Credit Suisse. Two quick questions; first of all, these temporary impacts on revenue in the fourth quarter, should they help you in Q1 so you should see far less than normal seasonality? I don't know 10%-15%, could you clarify that? And second of all for Paul, I guess with the improvement in operating income is it fair to assume that this year you'll be free cash flow positive given that I think you burnt around 700 million euros after restructuring and all of the costs in 2009?

Paul J. Tufano

Well, let me take your first question with regard to the free cash flow positive in 2009, clearly that won't be the case. I think we still have a cash burn of about 690 million euro. As we look at 2010 our goal is to get it as close to a cash flow breakeven as possible and that's the objective.

Q1, as we said before I think that Q1 we might do a little better than the seasonality we normally see.

Ben Verwaayen

Yeah. And we're not going to give a percentage on that. It's a good try, but I don't think that would be wise.

Peter

Question from the room, please.

Unidentified Analyst

Yes, hello. Two questions on the balance sheet, please. The first one is now that you expect growth to return, how do you see your working capital going forward? Do you think that you've come down as much as you can and now it's pretty much stretched and that growth returning you'll have to increase your working capital? And the second one is you've mentioned quite a lot that you've improved your balance sheet situation over a year ago. How comfortable are you today with your balance sheet going forward, especially that you have big refinancing deadlines coming up in 2011?

Paul J. Tufano

Okay. Well first of all, I think we have secured all of the requirements to finance 2010, in June the put and January 2011 so that doesn't concern me at all. With regard to the balance sheet and being able to harvest more cash off the balance sheet, I think we still have opportunity. Now in the inventory area I think that there are opportunities in reengineering of our supply chain to drive better inventory performance even with revenue increasing and that work is currently under way with our operations teams as we go through it.

And on the payable side, we still have an overdue balance that's still high. It's great that we reduced it, but the payable balance that we have, over dues is still higher than I would like and so those two areas will continue to be a focus area for us.

Peter

Another question from the bridge please.

Operator

Thank you. Alexander Peterc, please state your company name followed by your question.

Alexander Peterc - Exane BNP Paribas

Yes, hi. This is Alexander Peterc from Exane BNP Paribas. I'd just like to know given the part of the substantial revenue miss that we saw in Q4 was due to supply chain constraints both inside ALU and its suppliers, how do you look today at your rigorous supply management and would you perhaps look at working on an optimal supply chain for you and your customers' revenue generation rather than a tight supply chain per say and maybe this is a luxury that you could afford as end demand is normalizing? Thanks.

Ben Verwaayen

Well, many people ask questions like this on various elements where you put the screws a little bit on. I think we should do both. We should satisfy the market and we should have a very tight inventory and supply chain management. I think it is a— to be honest, if people ask you to let go of one to benefit the other, it's a false type of comparison because I could argue that the better your supply chain the more capable you are to fulfil the needs of your customers very close to what they really want at the time that they really want.

So I would raise the bar rather than lower the bar, and there is one other element to it. You need to know that in our market people were used to planning months and months in advance. So the engineers would be very comfortable to say in January in our network we will need 100 of these and they would talk about October or November or something. That's gone so people are very short term in what they really need and they are willing to change very, very rapidly. So here's a challenge that we have for our supply chain people; you have to bring it down in cost, and by the way, you have to be much closer to your customer, you need to be much more flexible because they may change configurations as they speak, and by the way, the warning time that you get from the other part of the market's also going down. That's the reality in which we live.

Now I think if we manage to get all those points really organized, not only Paul will be happy, I think our customer satisfaction will go up. So I'll take it as a must do end to end.

Peter

We'll take two more questions, another question from the bridge, please.

Operator

Thank you. Tim Boddy, please state your company name followed by your question.

Tim Boddy - Goldman Sachs

Yeah, thanks. Tim Boddy from Goldman Sachs. I wanted to ask about a couple of things. First of all, just how — you've obviously kept the 2011 guidance today. 2011 seems a very long way away at this point, but how do you plan to increase margins by the amount that you suggest? Is that you're depending on a strong return of growth, is it a question of some kind of mix improvement? If you could just articulare more around that I'd be grateful.

And then secondly, just in terms of the strategy you laid out around focusing on solutions and applications, one of the concerns I have was that the Chinese vendors have substantially more R&D resources at much lower cost so how do you over the long term actually out innovate the Chinese? What's the sort of secret sauce that Alcatel can bring that can't be matched by competitors with lower cost R&D? Thank you.

Ben Verwaayen

So one of the misunderstandings in the market is that the price for an engineer is the difference in the capabilities of your R&D. I don't buy that at all. Some of our competitors are hardly in China with their engineers and we have a hard time with some of their products to compete with them. So it's not where they're located. It's how efficient you are, what your focus is, and what your capabilities are. We have thousands of engineers in China and we are going to have a shift for products around the world. As I said, we're going to design for cost. Some will be designed for mature markets, some for not so mature markets. That's not so important than where your engineer is located so that's one remark.

Second, it's also not the number per say that makes the difference. It is what you do and what you don't. The what you don't is as important as what you do. I think that we, in the wireless domain just to take an example, develop 30% of features that are never used. Think about it, 30% of features that people say that they want it and never use. If you would know it up front and you would know which features they are you would reduce that, think about your time to market, your capabilities that you have to put that money to work somewhere else.

Now I think we are much closer to make choices there and better understand what it is to make those choices because we are much closer with the customer base and the people in the customer that really make those decisions what to market and what not to market. I think if you look to the margin expansion and our success rate there are two things that are truly important. First of all, we focus on the things that matter for the future — not just solutions, also the boxes. If you take 100G, that's a box that will help tremendously to bring the capacity that is needed. So if you're out there with a good box it helps with the solution and the solution needs to be helped by a good box. That's the way it works. And you need the sauce in between which is the service and the application capability to make it happen. But here's the answer to your question. It is mix, it is proximity to your customer, and it is the ability to be in the first wave. If you are in wave three or four, price is the only differential. I've said it before. So by being early, by being close, and capable, I think we have a world to again.

So 2011 is a long way from today for making projections. It's very short when you talk about the capabilities that you need to have into place to deliver, and I think we are well placed.

Peter

Great. We'll take one last question from the bridge, please.

Operator

Thank you. Next question is from Simon Leopold. Please state your company name followed by your question.

Simon Leopold - Morgan Keegan

Thanks. This is Simon Leopold with Morgan Keegan. I wanted to followup on the comments you made earlier in the mobility business. It's sounding like some of the 2G business in CDMA was the weakness. Versus my expectation that was really the bulk of the gap in sales this quarter so I'd like to try to understand the trajectory through 2010 because I'm assuming LTE is not a big contributor, so just want to get a sense of what's going on from a geographic and technological perspective, and just as a matter of clarification, the operating margin and services this quarter was quite good. If you could talk about the sustenance of that? Thank you.

Ben Verwaayen

So if you take the margin and services I'll take the mobility part. So it is absolutely true that if you look to analysis that's made about market share and mobility you look to us going down, that is solely focused on 2G. It is solely focused on 2G. In 3G our market share is much better than any 2G, and I will make clear on 4G our market will be much better than in 3G. And the reason for that is because you turn from a voice world into a real data video world. Because if you look to 4G, what it basically is, is a base station with a router on it and as you know, our IP capabilities are truly recognized and important.

You're right that LTE will not be a very big number in 2010. It will not also, on the other hand, be insignificant. I mean, it is very important and it is a building block for the future. I think that everything we have said is about the differentiation that we have in our product portfolio and building up to that please don't only think rands, you also have to think core networks, integrative core networks because people are not going to build four or five core networks — integrated core networks. Think about the capability that you then have from an optical domain and an IP domain integration of those. So I'll leave it with that and your imagination there, but this is a truly important door opener that is in addition to that. Paul?

Paul J. Tufano

Simon, on the question of the maintenance there is a variety of factors that affected that. First off, and we've talked about this earlier in the year, we had some underperformance on our maintenance outsourcing and NSI. Those groups have really worked hard to improve their overall margins and it came together in the fourth quarter for them so part of it is implementation of corrective action plans in those businesses that have borne fruit in the fourth quarter. The other thing quite also is the fact that maintenance had a fair amount of renewal activity and that carries pretty good margins. So the combination of those two brought the margins up.

Ben Verwaayen

Okay. Thank you all for coming, until next time. Thank you.

Paul J. Tufano

Thank you.

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Source: Alcatel-Lucent Q4 2009 Earnings Call Transcript
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