Alcatel-Lucent Has Upside Of 100-300%

| About: Nokia Corporation (NOK)

I have posted about Alcatel-Lucent (ALU) as well as Cisco (NASDAQ:CSCO) before, indicating my generally (long-term minded) bullish perspective. Since revenues and earnings for CSCO came in quite reasonable with increases of 7% and 20% respectively, the sell-off in response to the earnings release makes no sense whatsoever.

Obviously, investors were looking for positive news and unloading CSCO stock on good news, making a statement about their distrust regarding Cisco's longer-term prospects in Europe. I had positioned myself on the long side at that point of earnings release already and I used the setback to purchase even more shares to profit from this irrational sell-off. Even though I like to buy quality companies on the cheap, I am even more intrigued by turnaround stories such as AIG (NYSE:AIG) or Alcatel.

At $1.49 ALU trades close to a multi-year low and at the lower end of its 52-week range of $1.39 to $6.05. Now, ALU faced some challenges in the past, disappointed investors with weak earnings releases and the decline in the stock price keeps carrying on. In fact, short interest had been increasing until the end of April, with investors assuming the stock is going to head even lower. Short interest has increased almost continually since February (short interest 2,707,667) making a jump at the end of April to 28,669,687 in anticipation of ALU's Q1 numbers.

Indeed, Q1 2012 numbers, by themselves, did little to entice long investors. Revenues were either flat (Software, Services and Solutions) or declined with double digits. A 20% drop in the important Networking segment and a 9% decrease in the Enterprise segment stood out to capture investors' attention. Even though ALU faces serious challenges across all business segments, the broader picture does not look as bad. An overly stark concentration on negative events oftentimes opens the door for opportunity.

Investors have made overly negative experiences with ALU since 2007. Earnings in 2008 were coming in really bad with a loss of $7.2 billion, giving fuel to a continued decline in the stock price. However, earnings started to turn around with a materially lower loss of $723 million in 2009 and of $392 million in 2010. Earnings in 2011 increased to over a billion dollars. Earnings are not in a continuous decline as some would like investors to believe.

RBC Capital Markets has downgraded ALU with a target price of $1 at the end of April. A target price of $1 per share seems to reflect the pricing of a liquidation scenario. I do not believe this is warranted. ALU has significant value in its intangibles, its patents and has a long-term innovation record in its sector. Unless the company faces an immediate bankruptcy scenario, a stock price of $1, or $1.50, is just overly pessimistic. The valuation at this level is quite attractive: The P/E still stands at a ridiculous 2. Since the stock hovers around its lower end of its 52 week range, short interest is high, sentiment is all against ALU, I am initiating a long-position.

The earnings release in April has not altered my EPS estimate of $0.30 per share. In my previous post I have assumed a multiple of 10 to be a conservative, yet more realistic, multiple. My experience with deeply distressed securities has shown, however, that the return to investors can magnify by many times over when earnings stabilize and sentiment changes.

Based on my unchanged $0.30 EPS estimate, a multiple range of 10-15 would indicate a price of $3.0-4.5 per share marking an upside potential of 100-200%. If ALU is capable to continue to increase net income and free cash flow, I predict ALU to earn $0.40 per share in 2014. The same multiple range of 10-15 would lead to target price of $4.0-6.0 per share depicting an upside potential of up to 300%. Both multiples and upside potential are not unreasonable given the distressed security characteristics ALU exhibits.

Disclosure: I am long ALU, CSCO, AIG.