It looks like Alcatel-Lucent's (ALU) turnaround has lost its wheels. The French telecom company's shares are down 14% since it released its second quarter report. The sell-off was sparked by a huge bottom line miss, as Alcatel reported a loss of 0.11 Euros while analysts were expecting the company to breakeven. Moreover, there are concerns around slowing revenue growth as Alcatel's revenue fell almost 5% year over year.
Alcatel missed the bottom line estimate as a result of restructuring and financing expenses, which can be expected as the company is trying to align its business to tap new opportunities.
But, in my opinion, investors shouldn't be ditching Alcatel-Lucent yet. The last quarter might have been weak, but the telecom giant looks set to improve in the long run, driven by its investments in new products, growth in the emerging markets, and the secular growth in connectivity applications.
Product development is key
The company is transitioning its business from legacy to new generation of products and technologies. Now, this has allowed the company to land more customers.
For example, in core routers, Alcatel-Lucent registered four more design wins in the second quarter. This includes a deal with a major European service provider. Alcatel has now recorded eight wins in the first half of the year in this segment. More importantly, Alcatel-Lucent recorded several crucial wins in LTE overlay for ultra broadband access. It currently manages 55 contracts, and these should continue adding to its revenue in the long run. As of now, there's robust momentum in this segment with a total of 71 customers at the end of June.
These are, no doubt, impressive moves. Core networking is the second-biggest revenue generator for Alcatel with 42% of revenue, and since the company is landing orders for more routers it should continue getting better.
Strong customer base and small cells
Alcatel's fixed access segment also is rolling forward nicely. The company is witnessing robust customer additions in both copper with VDSL2 vectoring and fiber. Moreover, Alcatel-Lucent recently won a contract with AT&T (NYSE:T), adding the telecom major to its user-defined network cloud supplier program, popularly known as Domain 2.0.
With this move, Alcatel is now on track to benefit from AT&T's solid growth plan. According to a press release:
"Supported by its Domain 2.0 supplier program, AT&T is putting customers at the center of the network with a modern, cloud-based architecture that is a global first at this scale. The shift will build on AT&T's best-in-class network status, and is expected to significantly reduce the time required to pivot to this architecture and accelerate time-to-market with technologically-advanced products and services."
Apart from AT&T, Alcatel has gained solid traction at other carriers. For example, it has gained several wins in virtualization and SDN with Telefonica (NYSE:TEF), China Mobile (NYSE:CHL), NTT DoCoMo and Mobiliy in Saudi Arabia. Vodafone (NASDAQ:VOD) also is using Alcatel's expertise in small cells.
This is yet another growth market from which Alcatel should benefit. According to ABI Research's report on Outdoor Small Cells, spending on small cell equipment is expected to increase at a terrific rate of 33% this year. The growth will be driven by telecom carriers such as AT&T, Verizon (NYSE:VZ), Vodafone (NASDAQ:VOD), Telefonica, etc. Now, Alcatel counts all these on its client list, which is why it is in a solid position to benefit from this market as well.
Broadband access to drive growth
Alcatel-Lucent is seeing tailwinds in the market due to wireless access, enabled by LTE deployments, which has favored its access segment. As a result, its wireless access business recorded both year-over-year and quarter-over-quarter growth of an impressive 30% in the second quarter on the back of coverage and capacity projects.
Access is the biggest revenue generating segment for Alcatel, accounting for around 52% of revenue last quarter, and houses both broadband access and LTE.
Now, as there is growing demand for broadband access, Alcatel's overall revenue should continue improving as this is its largest segment. Broadband penetration is increasing across the globe, and LTE deployments are gaining steam. According to Statista:
"In December 2012, there were around 1 billion HSPA and 60 million LTE subscribers around the world. The source estimates that by 2018 the number of LTE subscribers will have increased to almost 1.35 billion."
Hence, there is a lot of room for growth in the LTE market. As such, Alcatel is doing the right thing by tapping the LTE market with new products, and since it already has a strong customer base (as explained later), it should continue tapping the LTE market effectively.
Moreover, as per Point Topic, there will be an estimated 940 million broadband subscribers across the world by the end of 2018. Point Topic expects the figure to cross a billion by the end of the decade, from around 700 million at the end of last year. As such, Alcatel still has a lot of runway in the broadband business, and it is working hard on product development to tap this market.
Risks and challenges
Alcatel faces competition from peers such as Juniper Networks (NYSE:JNPR) and Ciena (NYSE:CIEN). According to MKM Partners, Alcatel is losing ground to Juniper in edge routing and to Ciena in optical routing. This can be seen by a 13% year-over-year drop in core networking revenue in the previous quarter.
In addition, Alcatel has a huge debt burden of $8.5 billion, which means that the company might be under pressure due to high interest costs. However, the good thing is that Alcatel has an identical cash position of $8.3 billion, and since it is disposing off assets, the debt figure should come down going forward.
Finally, Alcatel is delivering an improvement in gross margins. Last quarter, its gross margin improved 140 basis points year-on-year to 32.6%, driven by cost savings. Alcatel is focusing on improving profitability by continuously improving its fixed operation costs. Hence, it is not surprising why analysts expect its bottom line to deliver terrific annual improvements of 101% a year for the next five years, which makes Alcatel a solid bet at just 15 times forward earnings.
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