Q4 results confirmed our investment thesis (see our earnings preview article here): Alcatel-Lucent (ALU) is executing well on its restructuring plan and is on track to exceed the Shift plan targets. We performed a valuation of the stock, which suggests that the rerating is likely to continue: we get to a target price of EUR6.2 / $8.4.
Strong Q4 earnings
Despite lower-than-expected Q4 revenues (EUR3.93bn/$5.34bn vs. EUR4.14bn/$5.63bn), Alcatel significantly beat gross margin and EBIT expectations for the quarter: 34.3% and EUR307m respectively vs. the Street's 32.2% and EUR267m expectations.
Obviously, the -4% revenue growth in Q4 was not a great performance but in our view, the miss should not be seen as a major issue as Alcatel has been recently dropping non-profitable contracts/businesses in order to focus on higher-margin products and contracts.
This improving revenue-mix clearly drove the gross margin upside, while higher-than-expected cost savings (above EUR100m/$136m in Q4 and around EUR360m/$490m for the FY, ahead of the EUR250-300m/$340-407m target) gave an additional boost to EBIT.
The revenue momentum should remain uninspiring in the short-term, as Alcatel continues to revamp its product & contract portfolio and gets rid of poorly performing assets (such as the Enterprise business which has just been sold for EUR270m/$367m). But more importantly, this revenue-mix shift and asset disposals should enable the group's margins to remain on a positive trajectory:
1/ Alcatel's gross margin could improve 200bp by 2015, as the group has just started revamping its portfolio. Alcatel is in our view at an early stage of its gross margin recovery, as illustrated by its Q4 margin improvement (+400bp vs. only +100bp on average in the 3 previous quarters).
2/ Disposals could add c.200bp to Alcatel's EBIT margin in our view: we estimate that the Enterprise business disposal will improve Alcatel's margins by c.50bp going forward. Assuming similar conditions for next disposals (Alcatel targets EUR1bn disposals), we get to this 200bp figure.
In the same time, 2014-2015 cost savings are expected to spark a 400bp margin leverage… at least. As we said in our previous article, Alcatel plans a total of EUR1bn/$1.36bn of cost savings (mainly SG&A), but the group's SG&A/Sales ratio could in our view get close to Ericsson's (ERIC) standards (11%). This would suggest EUR350m/$475m upside on Alcatel's savings target.
Our valuation scenario
In all, Alcatel could get to an EBIT margin of at least 10% in 2015, vs. 2% in 2013. If we cautiously assume revenues around EUR15bn/$20.4bn (i.e. flat, as organic revenue growth is offset by disposals), we get to a EUR1.5bn/$2.4bn EBIT. Taking into account roughly EUR200m/$272m of financial and below-the-line costs, we get to a EUR1.3bn/$1.77bn net profit (remember that Alcatel is not expected to pay tax soon thanks to a tax loss carryforward).
We then applied to this net profit figure Ericsson's 2015 P/E of 13.5x, which yields a EUR6.2/$8.4 per share valuation (+88% upside).
We also performed Alcatel's valuation with a normative tax rate of 30% as the tax loss carryforward will be consumed one day or another. In this case, we get to a EUR4.4/$6 per share valuation (+32% upside).
Downside risks to our valuation include a weaker-than-expected telecom equipment market that would affect both revenues and gross margins and/or a rising competitive pressure in key segments for the group (such as small cells, SDN, core routing...).