Alcatel-Lucent (ALU) recently announced its full year earnings and gave updates about the expectations of the company over the next 12-18 months. We saw considerable movement on "The Shift Plan", gross margin and the cash flows of the company. I am sure the majority of the readers have read the full transcript on Seeking Alpha - I also shed some light on the major areas in my previous article.
Some key points in the earnings announcement prompted me to revise my valuation model for the stock. These updates to the model resulted in a substantial change in the calculated fair value of the stock. As a result, I have decided to raise my price target for Alcatel-Lucent. Some of the key factors that prompted me to update the model are listed below.
- Improving Gross Margin: The first factor is the improvement in the gross margin. Alcatel-Lucent has recorded considerable improvement in its gross margin. The gross margin for the fourth quarter was 34%, and for the full year it stood at 32.2%, compared to about 30% a year ago. Furthermore, I gathered from the earnings call that the company expects further improvement in the gross margin over the next twelve months. As a result, I have assumed improvement of another 100 basis points for the current year and further 100 basis points for the next year. After 2015, I have kept the gross margin constant at 34%.
- Robust Growth in the U.S.: The U.S. is the biggest market for Alcatel-Lucent - the company generates about 42% of its total revenues from the U.S. Verizon (NYSE:VZ), AT&T (NYSE:T) and Sprint (NYSE:S) are its biggest customers according to the revenue share. Verizon, AT&T and Sprint account for 33% of its total revenue. Michel Combes clearly said that he expects the robust growth in the U.S. to continue over the next twelve months.
- IP and Ultra-Broadband: It was also clear from the presentation that the growth in the IP and ultra-broadband segment is expected to remain strong. Furthermore, Michel Combes also hinted that gross margin from the IP segment will likely get better over the next year.
Model and Assumptions
Over the past three years, revenues have been showing a decline in the networking equipment manufacturing sector. However, the fall in revenue is slowing down and the company will likely start to see growth in revenue soon. As I have mentioned above, the growth in the key segments and geographic regions is expected to remain strong for Alcatel-Lucent, which should enhance the revenue growth over the next 12-18 months. I have been slightly optimistic with my assumptions of the model - for the first year (2014), I have assumed revenue growth of 1.5%. However, total revenues have been adjusted downwards for the sale of the enterprise unit - the unit contributes around $1 billion to the total revenues and the sale is expected to be closed in the third quarter. As a result, the company will continue to report the revenues in its statements for the most part of the year. Revenue growth will reach 2% in the following year. By then, I believe the company's new strategy will start to bring in substantial revenue growth; as a result, the assumed revenue growth for the following five years is 3%. In the end, I assume that the growth will fall down to 1% and continue indefinitely.
ALU's cost of sales currently stands at around 68% -- however, the company's historical cost of sales has been around 65%. As a result, I have assumed a declining cost of sales to 66% from 2015 to the total valuation period. I believe as the company focuses its efforts on one or two core growth areas; it will allow it to manage its cost better and the gross margin will increase. Furthermore, total operating expenses are around 31% of total net sales. However, we have already seen a decrease of over $400 million under the shift plan and I am inclined to believe that the company will achieve the target cost reduction during the current year. As a result, I have assumed operating expenses to be close to 28% of the total net sales, mainly due to the sales of LGS and enterprise units. However, for the remaining period, I have assumed operating expenses to be close to just over 27% as the company will try to bring operating costs further down. Finally, the tax situation for ALU is complicated as the company has been carrying tax benefit due to the accumulation of losses. For the sake of simplicity, I have ignored the prospect of future tax benefits and assumed a tax rate of 30%. Pro-forma earnings are shown in the table below.
Earnings will gradually get better for Alcatel-Lucent as the company gets out of the recent slump and focuses more on the high growth areas. If the company is able to grow at the assumed rates for the next five years, then earnings and margins will be substantially higher. ALU has an incredible R&D team that can provide innovative products to the company. If the pipeline of the company keeps on delivering innovative products, then my assumptions might become extremely conservative and earnings will be substantially higher.
For my valuation purposes, I have used a discount rate of 11% -- I believe this discount rate fairly depicts the risk associated with the stock. Below table shows free cash flows, adjustments for different items and valuation.
For the free cash flow calculation, I have taken net income as the starting point. All of these net income figures represent projected net income based on above mentioned assumptions. To reach at free cash flows, I have made adjustments regarding, depreciation, amortization and other non-cash items such as gains/losses on equipment sale and taxes. Furthermore, investment in fixed and working capital has also been taken into account. Non-cash items include depreciations and amortization along with stock based compensation - these items are added back to net income.
However, investment in fixed capital and working capital has been deducted from the net income to reach at the free cash flows. I have assumed investment in fixed capital at about 15% of incremental sales. Alcatel-Lucent spends substantial amount on research and development; however, investment in fixed capital has been only about 25% of the total R&D expense. As a result, I believe the company will have to spend about 15% of incremental sales on fixed capital in order to support the growth in sales. In addition, I expect the company to increase investment in working capital by 5% of incremental sales over the valuation period.
Free cash flows beyond 2022 have been projected at a constant growth rate of 1% and discounted at the discount rate of 11% (adjusted for growth rate) to calculate terminal year free cash flows. After calculating free cash flows for each year, I have discounted those free cash flows at 11% to reach at the present value, and added them to achieve about $15.8 billion in discounted free cash flows. According to my free cash flow model, Alcatel-Lucent should be trading at around $6.87 per share. At the moment, the stock is trading at around $4.31 per share.
The things are falling in place nicely for Alcatel-Lucent - the management is delivering on its promises and the market is also showing attractive growth. The company has been able to grow in almost all of its key areas and the future growth is expected to be robust. As I mentioned in my previous article, I expect the shift plan to come into full swing during the current year, which will allow the company to substantially decrease its costs. Furthermore, asset sales will enhance the overall financial position of the company and make its balance sheet look a lot better than the current position. I believe Alcatel-Lucent will continue its upward movement and the shareholders will be rewarded over the next 12-18 months.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.