Alcatel-Lucent (ALU) recently announced that it is entering the core router market. This was expected since the company started on the FP3 chipset last year. The router will be called 7950 XRS (Extensible Router System), and will come in three models: the 7950 XRS-40, 7950 XRS-20 and 7950 XRS-16c. It took Alcatel-Lucent more than three years to develop these product lines. The company has been selling routers for the past decade, but seems unable to capture the market. This guarantees additional revenue streams for a company.
This announcement shakes up the area that Cisco (NASDAQ:CSCO) and Juniper Network (NYSE:JNPR) have traditionally dominated. This is also timely as other major equipment vendors are currently restructuring their businesses to adapt to lower demand in markets as operators are switching from 3G networks to LTE. For example, Nokia decided to focus on more profitable LTE contracts with its recent deal with T-Mobile USA after it struggled with repeated losses. Ericsson also has a solid grip on the US LTE market, but is still encountering difficulties.
The move is also seen to capture the increasing demand for online video and data. The rise of smartphones and tablets is the main driver for this one. At the same time, the rise of cloud based services and personalized content is also one of the driving factors. This scenario forces network operators to accelerate their capacity upgrades to adapt to both consumer and corporate needs.
According to Alcatel, network operators will spend $4 billion per year on IP core routers. Bell Labs also estimated that global energy consumption for core routers will exceed 1.8 Terrawatts in 2016, equivalent to 128,000 homes. Alcatel's new offering can scale from 6.4 Tbps to 32 Tbps. It can also support 160 100 Gigabit Ethernet ports in a single system. This is 5 times the density of other existing core routers in the market. It also uses over 60% less energy than most core routers, which makes for a good selling point to customers.
Network Operators welcome Alcatel's move
Most customers are looking for alternatives that will allow them to support increasing volumes of data. While Cisco and Juniper have deep competitive positions in this space, it does not guarantee their continued success. Alcatel has a good chance to grab market share from these incumbents.
Last week, Verizon (NYSE:VZ) said that it will become the first network operator to use Alcatel's 7950 core router. Verizon currently uses Alcatel's 7750 SR edge router. Verizon is upgrading its wireless network capabilities to address growing network traffic demand.
NTT Docomo has appointed Alcatel to build its Internet Protocol network. This will give NTT enough speed and capacity of its network to address the growing demand of the Japanese market. NTT also said that this will lower its operational costs and improve efficiency.
Other network operators have applauded the move, most notably Alcatel's existing customers. BT Global Networks and Systems said that the core router will handle the increasing traffic volumes and growth in its cloud services.
Defensive moves from Cisco and Juniper
Given the warm reception of the market, Cisco and Juniper is expected to release a new router anytime soon. Without a new router to match Alcatel's, there is a big possibility that they will lose their existing clients to Alcatel.
Juniper has recently announced that it has increased the capacity of its TXP multichassis interconnect from 6.4Tbps to 16Tbps. This will allow companies to connect multiple routers to increase capacity.
Impact on Alcatel's Bottom Line
The router business operates under the network division. It has revenues of more than $9.6 billion, which accounts for 60% of the total revenues of the division. While it is too early to conclude that Alcatel will be successful in its bid to compete in the router space, it is safe to assume that this segment will remain the main revenue driver of the division.
Analysts expect the company to earn $0.20 per share this year. This translates to a decline of 57% compared to the same period last year. Over the next 5 years, the company is expected to grow its income by 6% a year. This is higher than the expected decline of the industry.
Alcatel has a net profit margin of 3%, slightly higher than the industry's average of 2.44%. Going forward, its margins will improve as the company focuses on higher margin products like its core routers.
Valuation: Alcatel is too cheap to ignore
The stock is currently trading at 8 times 2012 earnings. This appears to be a somewhat depressed level, as the market is expecting a contraction of 50% for the year. In contrast, Cisco trades at 12 times earnings and has a dividend yield of 0.73%. On the other hand, Juniper is valued at 30 times earnings and carries a dividend yield of 1.27%.
It's surprising that a company with strong economic prospects is trading at depressed valuations. Alcatel has several growth catalysts which will have an impact on its future profitability. I believe this will translate to a higher stock price in the future. Among the catalysts include increased growth in the mobile and broadband data business and growing IP markets. It will be a matter of time before the market recognizes this.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.