The initial reaction to Alcatel-Lucent's (ALU) Q2 earnings has been negative, as it looks like investors are concerned about the poor free cash flow generation in the quarter (-$275m). This poor number is understandable: margins are rising, but are still weak, and cash outflows related to the restructuring are still significant ($154m). In our view, it's just a question of quarters before free cash flow improves, as margins are structurally improving and restructuring costs will gradually go down. We remain convinced that patience will be rewarded.
Indeed, Alcatel-Lucent's key Q2 figures and metrics were strong once again. Despite revenues very slightly below consensus ($4.39bn vs. $4.38bn), gross and operating margins came in well ahead of expectations, leading to an operating income of $182m vs. the Street at $150m. EPS of $-0.01 was only in line due to a non-cash financial expense.
At the top line level, Alcatel-Lucent continues to stand out relative to other network equipment vendors, with Q2 revenues up 5% like-for-like (when excluding the Managed Services business, which the company is gradually exiting). This was driven by Wireless (+28%), where the group keeps gaining market share, Asia (+25%) and by resilient performances in North America, where AT&T (NYSE:T) and Verizon (NYSE:VZ) have reported higher-than-expected capex.
In all, we remain confident that underlying revenue dynamics should remain well-oriented, even if reported figures are likely to remain uninspiring as Alcatel-Lucent revamps its product portfolio, drops poorly-profitable Managed Services contracts and gets rid of non-core assets. Nevertheless, Alcatel-Lucent will have to comment on the surprisingly weak core networking revenues in the quarter.
At the operating profit level, both the gross margin (+140bps to 32.6% vs. consensus around 32%) and cost savings ($126m in Q2 and $317m in H1 vs. FY guidance at $335-$400m) surprised on the upside. This makes us confident that the company is well on track to reach our 10% margin expectation in 2015 vs. guidance at 8% (for full details, please see our article "Alcatel-Lucent: The Stock Could Get Above $8"). Note that our expectation is based notably on the assumption that upcoming disposals (Alcatel-Lucent targets $1.34bn disposals) could improve group margins by 200bps. Interestingly, the company is making progress on the disposals front, as it announced the IPO of its submarine business. This move is likely to give the business a higher value than a fire sale, and to enable Alcatel to gradually reduce its stake.
Following the strong Q2 figures, EPS expectations for 2014-15 are likely to tick higher (+3%-4%, in our view). We stick to our above-consensus margin expectations for 2015 (10% vs. 8%), and reiterate our $6-$8.4 valuation range (full details here).
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