This article deals with two networking and service providers that I believe are undervalued and misunderstood by the market. When companies experience temporary challenges, investors usually rush for the door instead of picking up great companies on the cheap. The companies in this article are thought to have lost their competitive advantage as investors are overly influenced by earnings and cashflow volatility. In my opinion, investors underestimate the immense innovation potential and depth of knowledge inherent in these companies.
Alcatel-Lucent (ALU)
ALU is a global telecommunications corporation providing telecommunication solutions to service providers, enterprises, and governments around the world. The company focuses on fixed, mobile, and converged networking hardware, IP, software, and services and competes with Cisco (CSCO), QualComm (QCOM), Nokia (NOK) and Ericsson (ERIC).
ALU investors know what pain is. Since the stock is in a more or less steady decline since 2007, investors were either losing their nerves and selling their stock or still holding on to it, posting massive paper losses. RBS Capital just recently downgraded ALU from sector perform to underperform issuing a price target of $1, which represents a 33% downside from current market prices. In addition, a critical note was issued on Research in Motion (RIMM) which is not very surprising given the position of the company in its respective markets.
ALU is one of the smaller competitors in the field, not as strong financially as other competitors and faces some headwinds. ALU has been taking some hits from analyst up- and downgrades and was punished for revenue- and earnings volatility. The main challenge for ALU lies in convincing the market that it is able to deliver a solid product and service base that allow for a more consistent, i.e. less volatile, earnings and cashflow stream. ALU has been punished for a significant drop in revenues in Q1 2012 and competition impacts financials. More importantly, as more constructively, ALU has serious value in its patents, which are part of over $7bn in intangible assets/GW on the balance sheet attesting to the innovative strength of the company. In addition, the recent sale of Genesys with proceeds of ca. $2.5bn will allow the company to more aggressively invest into its product and innovation portfolio.
ALU trades at a ridiculous trailing P/E of 2 and a forward P/E of 5, close to its 52-week low and 78% off its 52-week high: All of them great indicators for value in my opinion. Is this valuation level appropriate given the challenges ALU faces? I hardly think so. Lets not forget that Alcatel reported earnings in 2011 that beat consensus estimates and buy ratings roughly equal sell ratings. ALU is more priced for liquidation rather than as a going concern. With an EPS estimate of $0.3 per share and a multiple of 10, the stock has 100% upside. In my opinion, the negative sentiment in the market regarding ALU clouds the inherent value of the company, its innovation strength and assigns a too low a value to its earnings prospects.
Cisco
CSCO was brought to my attention when the company made headlines after disappointing earnings last year.
CSCO's current product and service offering focuses on Enterprise networking and Service Providers, Small Businesses and Home Users. CSCO investors know that over the last years the company underestimated the significance of data centers and clouds as a main revenue driver going forward in the corporate segment. CSCO seriously underestimated the impact of growth rates in workloads processed in cloud data centers.
A Forbes article attested to this:
Cisco's Global Cloud Index is built on a series of predictions on the growth of global data centers and cloud-based IP traffic. The vendor estimates that global data center traffic - cloud and non-cloud - will grow four-fold from 2010 to 2015 and reach 4.8 zettabytes annually by 2015 - growing at a rate of 402 exabytes per month by that time.
The cloud computing piece of it will grow 12-fold over the forecast period, and represent over one-third of all data center traffic by 2015. Further, Cisco predicts, more than 50% of all data center workloads will be processed in the cloud.
Even though CSCO has been modestly successful in maintaining its gross margin and initiated a cost reduction program to control operating expenses, margins will still be under pressure resulting from a high level of competition especially in the networking segment. I am somewhat optimistic that CSCO will be able to more efficiently deliver value to its client base and increase switching costs, maintain margins and maybe even slightly improve market share. Now, the question for the investor is: How much premium should be assigned to a company that has a strong customer base buts still lags in its position in a key growth segment of its core business? Since I am market-oriented in my approach to valuation, a leading P/E ratio of 12 for a company that can generally be classified as growth, is too low. Even though CSCO lags performance in a key segment I can still see EPS per share growth of 10% or more for 2012/2013. With an estimate of $2 EPS per share and a more appropriate multiple of 15, the company would be worth $30 per share, marking a 50% upside. The coming economic expansion is more likely to enhance both CSCO earnings and multiple.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ALU over the next 72 hours.
