- The stock's performance year-to-date can hardly be justified by the telecom equipment market dynamics or by Alcatel's (improving) fundamentals.
- Alcatel-Lucent is still at a very early stage of its margin recovery, and could get to a 10% operating margin by 2015 vs. consensus around 7-8%.
- Applying Ericsson's 2015 multiples to Alcatel-Lucent, we get to a valuation range of $6-$8.4.
Capex dynamics, business exposure and deal momentum remain supportive
Solid Q1 earnings and Q2 guidance from Juniper (NYSE:JNPR) were obviously a relief for telecom equipment stocks, which have been under pressure in recent weeks. The figures pointed to a relatively healthy telecom infrastructure market in developed geographies, driven by next-generation (LTE) networks and by solid demand from cable & content players and social media companies.
Against this backdrop, we see no reason why Alcatel-Lucent (NYSE:ALU) would not do well and report at least in line with expectations in Q1. The company has a large exposure to the growing IP routing market, and has been enjoying a rich deal momentum recently, with contracts announced with China Mobile or Elisa in Finland. And in the US, Alcatel-Lucent has a more attractive customer mix than some of its peers: the group has had consistent business at Verizon (NYSE:VZ) and AT&T (NYSE:T), and gained share at Sprint (NYSE:S) recently, while Nokia (NYSE:NOK) and Ericsson (NASDAQ:ERIC) are exposed to T-Mobile (declining capex).
In all, the underlying revenue dynamics should remain well-oriented, even if reported figures are likely to remain uninspiring in the short term as Alcatel-Lucent revamps its product portfolio, drops poorly-profitable contracts and gets rid of non-core assets.
Alcatel is at a very early stage of its margin recovery
Importantly, this revenue-mix shift and asset disposals should enable the group's margins to remain on a positive trajectory. We reiterate that Alcatel is at a very early stage of its margin recovery: earnings have started to significantly surprise on the upside in Q4, but there's more to come in coming quarters as the termination/disposal of poorly-profitable contracts and businesses flows through the P&L and as cost savings ramp up.
Our scenario is that Alcatel gets to an EBIT margin of at least 10% in 2015 vs. 2% in 2013 and vs. consensus at 7-8%. We get to this figure assuming:
1/ a 200bps gross margin improvement, based on the sharp margin improvement seen in Q4 (+400bps vs. only +100bps on average in the 3 previous quarters).
2/ a 200bps margin gain from upcoming disposals, assuming conditions for next transactions (Alcatel targets $1.37bn disposals) are similar to those of the Enterprise business (we estimate that this deal will improve Alcatel's margins by c.50bps going forward).
3/ a 400bps margin leverage from cost savings. Alcatel plans a total of $1.37bn of cost savings (mainly SG&A), but the group's SG&A/Sales ratio could, in our view, get close to Ericsson's standards (11%). This would suggest a $475m upside on Alcatel's savings target.
We value Alcatel-Lucent in a $6-$8.4 range
If we cautiously assume revenues around $20.4bn (i.e. flat, as organic revenue growth is offset by disposals), we get to a $2.4bn EBIT in 2015. Taking into account roughly $272m of financial and below-the-line costs, we get to a $1.8bn 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 $8.4 per share valuation (112%+ 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 $6 per share valuation (51%+ upside).