Alcatel-Lucent: Gross Margin To Surprise On The Upside

| About: Nokia Corporation (NOK)

We believe that expectations for Alcatel-Lucent (ALU) are pretty low going into Q4 earnings (Thursday 6 February before the market opens in Europe), as telecom equipment peers Nokia-NSN (NYSE:NOK) and Ericsson (NASDAQ:ERIC) disappointed last week and as the company has a large earnings miss history.

This could pave the way for an earnings surprise and a stock rebound (Alcatel has dropped more than 10% in the last month) as we believe that the read-across from Nokia's Q4 is not relevant and as we see significant upside on gross and EBIT margins.

We don't see any relevant read-across from Nokia

Investors were worried about the Nokia-NSN performance last week. But in our view, the guidance was not that bad, notably the Q1 and Q2 guidelines, in view of the usual weakness of the telecom equipment business early in the year. We did not expect a miracle and indeed, there was no miracle. Anyway, we believe that the FY guidance offers upside as the US is not as bad as feared and as China supports growth (admittedly, with slightly lower margins).

Importantly, Alcatel has a different customer mix than its peers: the French group has had consistent business at Verizon (NYSE:VZ) and AT&T (NYSE:T) and gained share at Sprint (NYSE:S) recently, while Nokia and Ericsson are exposed to T-Mobile (declining capex).

Significant upside on gross and EBIT margins

Alcatel will have to deliver on its margins, as this is the metric investors currently monitor to assess if the Shift plan is going according to plan or if the company continues on its historical path (market share at the expense of profitability).

We believe that many analysts want to see the company deliver before adopting more aggressive expectations. This is leading to pretty conservative gross margin expectations for both Q4 13 and Q1 14 in our view:

- Alcatel's Q3 gross margin was 32.6%, on revenues of EUR3'668bn

- Estimates for Q4 point to a 32.2% gross margin on revenues of EUR4'137bn

- Estimates for Q1 14 (the weakest quarter for telecom equipment players) point to a 31.3% gross margin on revenues down 17% sequentially

Alcatel is likely to surprise on the upside as the company's CEO Michel Combes has been very vocal about:

- the group's client review, with Alcatel dropping non-profitable customers and contracts

- the change of the business mix towards higher-margin products

- cost savings of EUR1bn (mainly SG&A), which in our view are likely to be ahead of plan. We think that the SG&A/Sales ratio is likely to get close to Ericsson's standards (11%). This suggests EUR1.35bn potential savings.

Breaking into some key new markets: core routing, small cells, SDN…

On a mid-term view, we believe that the sky is becoming clearer for Alcatel as the company is breaking into promising markets, such as core routing, Software Defined Network, or small cells…

Alcatel is notably a pioneer in small cells, which are used by mobile operators to extend their service coverage and/or increase network capacity. With small cells, mobile operators can offload traffic as much as 80% during peak times. ABI Research estimates that by 2015, 48% of mobile data traffic will be offloaded from the macro network.

In our view, Alcatel has a huge market opportunity here that is still overlooked by the Street: the small cells market is expected to reach roughly $3bn by 2017, and Alcatel is well ahead of its competitors Cisco, Ericsson and Huawei (by 12-18 months in our view) with 39 contracts already signed and 20 ongoing trials.

Some argue that small cells are likely to cannibalize macro cells (ongoing LTE deployments). But we think that in this phase of strong data growth with bandwidth reaching its limits in many parts of the world, telecom operators are more likely to focus on net adds and ARPU by offering a higher quality of service than on capex discipline. European carriers have a major opportunity to upgrade… or could face the risk of being sidelined.

Key data from Bloomberg

Disclosure: I am long ALU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.