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Alcatel (ALA)

Q4 2005 Earnings Conference Call

February 2nd 2006, 1:45 AM

Executives:

Charlotte Laurent-Ottomane, Vice President, North America Investor Relations

Serge Tchuruk, Chairman and Chief Executive Officer

Jean-Pascal Beaufret, Chief Financial Officer

Mike Quigley, President and Chief Operating Officer

Analysts:

Per Lindtorp, ABN Amro

Tim Boddy, Goldman Sachs

Mark Davies Jones, JP Morgan

Nicolas von Stackelberg, Sal Oppenheim

Robin Nazarzadeh, Citigroup

Richard Kramer, Arete Research

Inge Heydorn, Deutsche Bank

Remi Thomas, Cheuvreux

Per Lindberg, Dresdner Kleinwort Wasserstein

Adnaan Ahmad, Morgan Stanley

Ed Bell, Cazenove

Mark Sue, RBC Capital Markets

Alexandre Peterc, Exane BNP Paribas

Tim Daubenspeck, PacificCrest Securities

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Alcatel fourth quarter and 2005 earnings release conference call. Operator Instructions. Thank you. I would now like to turn the conference over to Charlotte. Please go ahead.

Charlotte Laurent-Ottomane, Vice President North America, Investor Relations

Hi everyone. Welcome to our fourth quarter and 2005 earnings call. We truly apologize for the delay. We’ve had some technical problems and we’ve had to change rooms and everything, but we are now all here. Also I’d like to just say that Pascal Bantegnie asked me to exceptionally handle the call today, so you will only have this one opportunity to hear my lovely accent. I’m here today with Serge Tchuruk, our Chief Executive Officer, Mike Quigley, Chief Operating Officer, and Jean-Pascal Beaufret, our Chief Financial Officer. We’re going to make a brief presentation. The slides are on the website. Unfortunately we’ve also had a bit of technical problems with that, but my understanding is that the website is back up, so you should have access to the slides. We will then answer your questions following the presentation.

Before we begin, I’d just like to remind you all that we will be making forward-looking statements under the Safe Harbor Act. Once again, thank you for your participation and your patience, and I’ll now turn the floor over to Serge.

Serge Tchuruk, Chairman and Chief Executive Officer

Thank you Charlotte, and also my own apologies for being late. Let me say first of all that we are quite happy with what we achieved in Q4 ‘05 which is, in many respects, a record quarter for Alcatel. As you can see on page 2, our revenue growth was close to 8% and we exceeded the 4 billion mark for the first time in three years, and our cash was up 24% sequentially. The operating profit came at 541, which is 13.2% operating margin, up 16% year-on-year, which is also as well the highest profitability we have ever achieved in a given quarter. The net profit was 344 million, 0.25 per share, including 0.02 eurocents of capital gains and fixed assets. And finally, we did achieve quite an improvement in our net cash situation, with net cash at 1.5 billion, up 1 billion sequentially, resulting from a strong free cash flow of close to 1 billion also. Year-on-year that was about 0.8 billion up, as you can see.

Turning to the next slide, which is an analysis of what happened on the segment analysis, the traditional ones. Well, you can see we noted an acceleration of the growth in fixed communications, as had been expected. This is 12% year-on-year. This is 24% sequentially, and this is primarily driven by a record quarter in access. We actually achieved 6.7 million lines of DSL, as well as a strong performance in our IP activity. The operating margin went up 17%, which is a high number. I don’t believe anyone is approaching this sort of profitability in fixed communications for the time being in our industry.

Mobile communications continued to grow strongly, 15% year-on-year, 15% sequentially, with good growth in some emerging markets and strong growth in applications also, double-digit operating margins. It was a mixed picture, by contrast, in private communications, as you can see, -5% year-on-year, although 25% sequentially, where we see revenue grow in most segments except space, which is still suffering from delays in the commercial order intake, and we are on page 3, actually, on the slides. So if I bundle fixed and mobile communications together, which pretty well represents our carrier business for fixed and mobile, we see about a 14% return on sales, as driven by just adding the two lines.

Now, going to page 4, this is the full-year evaluation analysis. We had a strong increase in profit and net income as you can see, and cash. Revenues were up 8% at constant growth and constant exchange rate. Operating profit was close to 1.2 billion, and 9.1% operating margin. These are flat average terms. The margin is a bit below last year, 0.5 below. If one, however, takes into account of the impact from mark-to-market valuation of our hedging instruments which did impact negatively in ‘05 by 0.7, compared to last year, then the operating margin was a bit higher.

Net income was close to 1 billion, which is 0.68 EPS, which is 61% improvement. This does include 0.17 of significant one-time items, capital gains from fixed and financial assets. Our net cash was at a record level, as I said, at 1.5 billion and for me, it’s the first time that we had a significant positive cash flow, free cash flow, as I will discuss later on. Looking at page 5, which is a higher level view of trying to evaluate what happened in ‘05, actually in the operating profit line we saw that the leverage from revenue growth did offset some gross margin erosion, which will be discussed in detail by Jean-Pascal in a short while.

On the net cash, in a nutshell again, we paid a cash conversion of our earnings and a lower restructuring outlay did result in a strong improvement in free cash flow. If I take the restructuring outlay there was a level of 600 million or so by the end of ‘04. It went down to 410 million by the end of ‘05, still distant from the 1% mark which we’ll be reaching. Now, looking at the segment analysis for the full year which is page 6, fixed communications resumed growth overall. It was defined in the first half and pretty effective growth in the second half, overall 1.7%. We now clearly emerge as the strongest player in the wireline segment, with leading position in key segments like broadband access, data optics and IT data.

Profitability was up from a year ago, reaching about 11% operating margin. Looking at the mobile line, we exceeded the 4 billion mark and grew overall 24% year-on-year, which is in our view the highest score achieved by anyone in our industry for ‘05. If I take the two last years, ‘04 and ‘05, our growth has been 33%. This means we are increasing our market share worldwide and I think in spite of a very competitive environment, we continue not only to gain market share but also maintain a two-digit margin. A mixed picture in private communications, as already stated, with growth in profitability close to Group’s average in enterprise and vertical markets, but satellite business suffered a setback from a lower 2004 order backlog and delays in the ‘05 order intake.

Now, looking at page 7, which is again a high-level view in terms of business analysis. The wireline business turned around at mid-year, as I stated. Basically the success of our strategy and the confirmation of our breakthrough in IT where we continue to report good success, and are now clearly emerging as a leader to what used to be a market. Also, the continued expansion of our wireless business, why do we achieve this? Because we chose radio-access multi-standard strategy, ranging from GSM to WiMax, which is well aligned today, and tomorrow no doubt, with the market trends, and this is well received by most of our customers. And also we are more and more evidenced that in terms of R&D we are more efficient than many others in that we can proactively get into the market trends. Two distinct trends in Private, continued growth in enterprise and vertical markets, and with momentum building up seriously in the vertical market, where we recorded good growth in two new cities, such as Dubai metro airport, that’s a three-digit contract. And satellite is weak but we see growth should resume in 2006 for satellite also.

Getting into a bit more detail, page 8, access was strong in H2, as we had expected, and for the full year, we had 21.6 million signs of DSL chips, and with I-SLAM, which is our IP DSLAM, being now about 15% of total shipments and getting a lot of momentum. We had very strong growth in IP, where we have now more than 100 customers to date, including Telstra in the Q4 of ‘05. This is a key technology to actually, and with a stand-alone. We saw some decline in MSWAN but the upswing in IP more than offset the decline in MSWAN. Good growth in optics, introduced in the summer arena. We are leading the market in 2001 in optics with a well-aligned portfolio to customer needs, and summer repeated some encouraging signs of good growth now. NGN/IMS, good growth in infrastructure and application. We signed up two contracts which are particularly meaningful. One is with ChinaSatcom, for extension, and also Telstra, and we’ll have more details in a while. And these couldn’t be expected, but still stronger than expected. The TDM contributed to decline, down to about 2% now of our ‘04 revenue. So, but we have seen how our growth is now resuming in the fixed communications arena announced more than 18 months ago.

Now, looking at page 9, our gains in mobile communications are again with a portfolio of radio access offering, which is very well cited with low ARPU markets, and a good position in payment and video applications. Two-digit profitability in a very competitive market because we are not taking just about any business we can, so we are getting to be more selective, and we have a lot of flexibility in our manufacturing base, with China playing a key role in it. And finally, we are still massively investing in NGN/IMS for the mobile field, infrastructure and Group application. Costs are high, very high actually, but also we have goodwill to believe the rewards are also going to be quite high. But for the moment we are again outpacing the market. Finally, if I take the private communications, the order backlog is being rebuilt. We are on page 10 by the way. We had a good H2 in enterprise, driven by IP telephony and applications. Transport signaling is still doing quite well, driven by a lot of renovation projects in rail main lines.

We returned to good growth in integration and services, driven by vertical markets and also fixed carriers, and as I said, declining revenue in the space activities. So in a nutshell, this is what we achieved, segment by segment. If you want to page 11 on the geographic table breakdown of revenues, I want you to look at the year-on-year variations, so the North America in U.S. dollars, we take this more or less the currency which better reflects growth, went up 7% in dollars. Actually, if one backs out the impact of satellite as we have done in the past, that’s more like 10%. It’s the same for Western Europe, 4%, up to close to 10% if one backs out the satellite thing. Asia Pacific was 3%. China was the market which shrank in ‘05 as we had mentioned a number of times again, but we did manage to get some growth, in other words we are strengthening our position on the Chinese markets against domestic suppliers. And the rest of the world grew by a large amount. This is measured in euros of around 15% across practically all the emerging countries.

So these were the introductory remarks and Jean-Pascal now will talk about the financials, and then after some ideas on the outlook, Mike, Jean-Pascal and I will answer your questions.

Jean-Pascal Beaufret, Chief Financial Officer

Thank you Serge. So, hi to everyone. First of all, I’d like to remind you that we –- three short reminders. It’s the first time we are delivering fully-fledged International Financial Reporting Standards compliant financial statement. You will see a lot of new disclosures, and we are of course more than happy to give you, after this call, all what is necessary for you to understand fully these new standards, these new disclosures. So far, the projections we have provided in IFRS were anticipations. You may have noticed, therefore, that the few final changes, which are not really material, have been made concerning 2004 restated figures. My second point would be that the Alcatel perimeter as reported in 2005 has been impacted by two deals. The one is the well-known space deal, as from July 1, 2005. The second is Native Networks acquisition with the member's carrier plus optical Ethernet transport solutions business we acquired in March for $55m.

Then just a brief remark about currencies. You all know our currency rate has been kept stable, on average for the full year 2004 and 2005 at 1 to $1.4. But there have been very strong changes in spot rates, when considering spot rates at the end of 2004 and 2005. The dollar went up 15% which has had quite a material impact on our balance sheet and on several other line items. So, I’ll try in this in next 10 slides, to insist on two messages which Serge already conveyed to you. First of all, Q4 is a very strong quarter in terms of operating and net margin, as well as in terms of cash flow, and the second message is that the free cash flow generation has improved from ‘04 to ‘05, and will improve in ‘06 as well.

Let’s look at slide, start from slide 13 maybe. We have had in Q4 last year a revenue performance of 7.6%, year-on-year. Growth has been reported at every segment except space and core legacy. The gross margin is 1% lower in Q4 2005 than in Q4 2004, but backing out the 1.7 impact, or impact, of mark-to-market, it’s a fair improvement, by around 0.7%. Costs have gone down by more than 1% in Q4 2005 versus Q4 2004. OP, operating profit, consequently is up by 1% and even more improvement has been observed by segment in the segments, if we back out in other segments. Restructuring, divided by three as from 2004, with 53 million is all about, all that is about, these costs were about the reorganization of space activities as well as the localization of our outsources.

Page 14, going through page 14 now, our net financial costs of 3 million are the result of the quite good management of past exposures. We are almost offsetting, or carrying cost of debt, 20 million, and our pension costs are 12 million, by several recoveries on certain accounts.

No new capital gains have been made in this quarter. This is only recoveries of our outstanding receivables. Net income from equity affiliates, we have basically ended the loss-making equity stage now. With taxes of 115 million we are in line with the quarter figures, and this charge is not reduced by any positive impact on DTA, deferred tax asset, recognition. So we went out with an EPS, earnings per share, of 0.25 per share. Standing back a bit and looking at the consolidated income statement for the full year 2005, it calls for a certain -- several items, several observations. First of all, as you may have noticed, revenue growth in the year has been driven notably by mobile, 24%, and followed by the very healthy ramp-up in wireline in H2. Gross margin reported, 35.3%, were down 2.4 below last year’s levels, but this included 0.7 impact of hedging, the dollar impact on hedging, which makes a decrease of 1.7. This is in line with what we said, all of 2005, about the price pressure and the competitive environment which we are explaining to you today.

Reported operating margin at 9.1% is 0.5% below operating ‘04 level. This means that revenue increases, basically, have largely absorbed the gross margin deterioration, demonstrating a significant volume leverage. OpEx recorded is flat, but as we said over last year, decreasing 2% before capitalization of R&D and capital gains, so we are in line with what was announced in Q3 2005. The share-based payment items, 69 million no change with what we said and what was anticipated. Going forward, we see this line at a similar level in ‘06 as in ‘05. Restructuring costs were slightly below our initial projection of 1% of revenues. We have added several restructuring actions in 2005. Going forward, we will continue to see that around 1% of all sales will be posted in ‘06. Disposal of consolidated shares, as you can remember, was the impact of the space transaction. Net financial costs of 50 million have reflected the carrying costs of reduced debt and several capital gains with, or disposal and the cost of our stake in one company for optical components. Going forward, we should see carrying costs of debt in ‘06 slightly below 2005, because of the lower level of gross debt, and pension charges are actually comparing similar to that of ‘05.

We are no longer with loss-making equity affiliates, and going forward, we are expecting in ‘06 a net positive contribution from our equity affiliates. A net tax charge of 91 million is resulting in an 8.5% rate, which is below the range we initially expected because of some favorable outcomes regarding system integration. Going forward, our estimate for normalized tax rate at the high end of the 10-15% range should be expected for 2006. EPS came out at 68 million, 0.68 per share, sorry, including the 0.17 per share of capital gains. The next slide, page 17, we provided you with some elements of the gross margin. It was just below a smooth transition from the two sets of standards which we experienced in 2004 and 2005, and give you all the necessary details just to make calculations on the underlying profitability of operations.

The 1.1%, this is in terms of high issue to revenues of our operating profit coming from big hedging and capital gains, which should allow to restate what has been profitability in ‘05. Coming now, page 18, to operating working cash flow, we were able -- have enjoyed in this quarter a significant recovery which was announced in terms of net inventories. You will see the net inventories go down by 360 million, and on the other had, we have more than offset the increase of net receivables, partly due to dollar impact, with additional down payments by our customers and more payables.

On a full-year basis, the impact on working capital on which we have invested is an addition of 3% of sales. We still believe that the level we would reach at the end of 2005 could significantly improve in terms of days, and we are working on that for 2006. Going forward, we maintain a 5-10% target, let’s say a range of targets. Having said that, we cannot discard that variation could happen quarter-to-quarter, depending on business seasonality and geographic mix.

The net cash reconciliation of Q4, page 19, is something I would like to stress further. We have gained 939 million in terms of free cash flow which is stemming basically from the higher transformation of our operating profits into cash with 598 million, and the recoveries I just mentioned in terms of working capital of 512 million. We have had as well a decrease in our restructuring cash outflows.

For the full year, net cash reconciliation, we will see that we started from a negative position in terms of free cash flow generation in 2004, due to significant cash outflows in restructuring, and we came out with a positive free cash flow in 2005. One comment -- two comments on the balance sheet, page 21, just the one comment and the usual comment on reserves, on the liabilities side of the balance sheet, going down in terms of reserves from 2 billion to 1.6 billion, but most of it, two thirds of it, is due to the restructuring figure and the creation of restructuring plan. The rest is a decrease in operating or in business reserves which changed basically from the conception of contract losses, and closing of reserve balances for big contracts at the end of the warranty period, as we said in Q3. The second comment on the balance sheet is to highlight that we have gone up in terms of equity from 4.9 billion to 6.2 billion, a 1.3 billion increase which is basically related to a the result and the dollar impact on all line items of our balance sheet.

Just to mention lastly that, page 22, we are on page 22, that we have repaid almost 300 million by anticipation of gross debt. The gross debt went down from 4.6 billion to 3.8 billion. This real improvement in our overall financial structure and balance structure and financial assets led the Board yesterday to decide to distribute a 0.16 dividend per share at the next shareholders meeting on June 1, 2006.

Serge Tchuruk, Chairman and Chief Executive Officer

Okay, thank you Jean-Pascal. So before we get into the Q&A, this is Serge, I give you some idea of the outlook. Turning to page 24, first of all, let’s talk a bit about the market. Well, overall, we expect the carrier market to grow above the mid-single digit in ‘06. Looking more precisely, we see some potential in fixed communications with growth accelerating, and driven by IPTV on one hand, and IP network transformation on the other hand. In IPTV we confirm the 20 million to 25 billion cumulative CapEx by 2010 that we expect carriers to spend, and we see growing momentum in full IP network transformation project at Telstra and DT’s 21CN project. On mobile communications, we expect some slowdown in the wireless market, although growth drivers remain, to a large extent, in the emerging markets, one billion new subscriptions, connections in markets like India, China, and Africa. Also growth of new usage in developed markets, music services, mobile TV and the like.

There are, however, some uncertainties still in the market, to a good extent due to the regulatory or government positioning. On the regulatory front, there are still some question marks on the part of developed -- deployment in Western Europe, notably with the agreement between the national regulators and the EU Commission. So hopefully this will be cleared up later on in the year. We still also of course have some question marks on the 3G timing and scenario in China, and the role of TDS CDMA but again, we expect some clarification pretty soon during the course of ‘06, leaving some room for interpretation of the timing again. And obviously, another element of uncertainty is the stated rate of the pick-up of IP network transformation.

Private communications should be driven by good enterprise and vertical market opportunities, so this is a way we see the outlook. Now, what regards our priorities will be at Alcatel next year. We have a lot of things to be done but if we were to select three top priorities, and we pretty well would weaken ourselves, number one is to increase revenues. Number two is to improve the free cash flow and to improve it beyond the decrease of restructuring cash outs, and number three, remain in control of OpEx. So what we see with those priorities in view in terms of revenue, we see first of all that Q1 ‘06 is going to be pretty strong in revenue with growth above 10%. This is the continuation of the good dynamics which we saw taking place at the end of ‘05 that has continued in the first quarter. We see, however, the H2 of this year probably having some other year-on-year growth rate than H1, which by the way, is contrasted to what happened last year in ‘05 actually. But we see overall that we are still quite confident that Alcatel should again outpace the carrier market as we did again in ‘05.

The net impact of the three priorities I mentioned a while ago in terms of operating profitability is that today we anticipate a slight improvement in the operating margin for the fiscal year ‘06 which obviously takes into account continuing competitive pressure in the market. But again, we underline the free cash flow generation objective which is absolutely a key in our management action. So this is where we stand, and now we are ready for the Q&A, my colleagues and myself.

Questions-and-Answer Sesssion

Operator

Operator Instructions. Our first question is from the line of Per Lindtorp with ABN Amro. Please go ahead.

Q - Per Lindtorp

Hello, Per Lindtorp here from ABN Amro. The question I have is regarding provisions. There seems to have been some misunderstandings during the day. I just want to make sure, or get you to confirm that provisions actually decreased profits in Q4, and it was not the opposite, so operating profit would actually have been higher if you would exclude the effect of depreciation and reversals of provisions? Thank you.

A - Jean-Pascal Beaufret

Shall I take the question?

A - Serge Tchuruk

Yes.

A - Jean-Pascal Beaufret

The exact answer, and correct answer is operating profit would have been 85 million higher had we not had allowed for provisions more than reverse provisions.

Operator

Our next question comes from the line of Tim Boddy with Goldman Sachs. Please go ahead sir.

Q - Tim Boddy

Yes, thank you. I just wanted to ask about operating leverage in your business. Clearly, as you indicate, the fixed communications market is beginning to accelerate, and we are seeing accelerating margins obviously in the fixed business in the fourth quarter. But as we look forward, maybe a little beyond 12 months, what are your aspirations for operating profitability? Will we see this acceleration in growth really deliver improving margins for Alcatel and in what amounts? Thank you.

A - Mike Quigley

Well, I tried to show that Tim. Aspirations, clearly continue to try and leverage the business. As we said, we expect to increase the revenue beyond the market rate for this year, 2006, generate more free cash and keep working on our OpEx, to keep that stable, and if we see the market develop, and we see as you asked beyond 12 months, which is always difficult to talk about, but if we see some improvement in what is now an overcrowded market, you could look forward to some good news. But it’s frankly, over the next 12 months, we set ourselves, as Serge said, the three areas of focus that we spoke about.

Operator

Our next question comes from the line of Mark Davies Jones with JP Morgan. Please go ahead sir.

Q - Mark Davies Jones

Thank you, one for Mike if I may. Can we have an update on the state of the debate out in Australia, and the Telstra build-out and where we might be on that, and any potential decisions that we need to keep an eye out in terms of the progress there? And while we’re on the subject, Deutsche Telekom today I think have said that they’ve gone ahead with some of their bills, despite the uncertainties on regulation there. Has Alcatel had any involvement to date in that first stage of build-out at Deutsche Telekom?

A - Mike Quigley

Okay, first of all on Telstra, just coincidentally, I’m leaving tomorrow night to head down to that part of the world, and as you well know, there is a debate that’s going on with the regulator around the issues of unbundled local loop, Mark. We will be doing something, frankly, that we’re quite well used to. We’ve had plenty of practice in it on the other side of the Atlantic in discussing unbundled local loop issues. So we will be saying the same thing as we’re saying to most regulators, that we encourage them to ensure that they don’t make it difficult for those carriers, those telcos who can, to invest in building out broadband infrastructure. So that’s the message that I’ll certainly be carrying to the regulators who I meet in Australia.

Meanwhile, Telstra have decided they’re going to continue with the project. We are the fixed infrastructure integrator, their partner in that area, so they’re continuing with the program with the exception of the business impacted by unbundled local loop. On DT, as you’re probably aware, we are a large supplier for DT but have been traditionally an access supplier. We supplied a lot of other equipment, and for the type of work they are now doing, we’ve obviously been in discussions with them for some time about different aspects of this overall program. But it’s probably a little bit too early to say too much more on DT at this point, other than to say, on the access side, there’s only one way for us to go, because we haven’t been a provider of access to DT up until this point in time.

Operator

Our next question comes from the line of Nicolas von Stackelberg with Sal Oppenheim. Please go ahead.

Q - Nicolas von Stackelberg

Yes, congratulations on the quarter. Can you hear me?

A - Serge Tchuruk

Yes.

Q - Nicolas von Stackelberg

I have a question regarding the gross margin. If you back out, hypothetically speaking, the satellite business, what would have been the gross margin, overall, in ‘05?

A - Jean-Pascal Beaufret

Something better!

Q - Nicolas von Stackelberg

Something better, yes but, by looking at other satellite players it’s obvious that they do have a significantly lower gross margin, and hence, it would be interesting also, to have a backdrop on all these speculations surrounding (indiscernible) and yourselves. I know you’re not going to comment on this but it would be helpful to give some kind of -- get some kind of feel of what the overall impact would be.

A - Serge Tchuruk

We are not reporting the gross margin by businesses and if I give you these sort of numbers, that’s exactly like if I give you the gross margin of the satellite. Yes, but quite yes, I could tell you that even in normal times, the satellite business generates less gross margin than the rest of our business because you don’t have any selling and marketing expenses in satellite. To sell satellite, you need half a dozen people, you don’t need thousands. To grow top-line gross margin of satellite with the rest has limited actually. But to answer your question qualitatively, yes, if you exclude my thinking, so that hopefully that will be the fact would impact positively the gross margin of it.

Q - Nicolas von Stackelberg

Maybe to just look at the private communications business unit, what would be the operating profitability level in that business unit if you backed out satellite? What’s your best guess?

A - Serge Tchuruk

I’m afraid I may give the same answer.

Operator

Our next question comes from the line of Robin Nazarzadeh with Citigroup. Please go ahead.

Q - Robin Nazarzadeh

Hi. Thanks very much. Robin Nazarzadeh with Citigroup. Two questions, if I may. The first is on guidance. I’m wondering whether, if we assume that we will see the same volume effect on margins in the first quarter, in other words, margin leverage. And if we do see that, would that not imply that margins in the second half of the year would have to be flat to down year-on-year to fit the framework of your guidance? And the second question is for Mike, which is around IP routing and switching and IP DSLAMs. Can you mention, Mike, you’d spoken of a target of 200 million for 2005 on IP routing and switching. Can you talk about how you did on that target, and maybe give a view on the IP DSLAM market for 2006 please?

A - Serge Tchuruk

Okay, Jean-Pascal, could you take up the first part?

A - Jean-Pascal Beaufret

Yes. The slight improvement on margin is on a full-year basis. Mechanically it has shown that the first quarter or the first half year margin would be better than mechanically you will come out with our results for the second half year will be worse. But we are saying in the same time that the visibility for the full year is less good on the second half, so we cannot preclude that the margin will be, let’s say, good in the second half as well. We are not taking any stand on the operating profit on the second half of this year.

A - Mike Quigley

Okay. I’ll answer, Robin, your question on IP routing. Yes, we absolutely achieved 200 million in revenues we were talking about in our IP routing product family. That puts us in our calculations for 2005 at about 15% market share, which puts us number three, actually number three worldwide in EDGE routing. I think what’s important though is that we are number two in Europe in EDGE routing. And I just want to clarify what is sometimes a misunderstanding. Our EDGE routing is not just dependent on large integration deals, or large IPTV deals. In fact, 50% of our business in IP routing is based on enterprise services, BGP VPNs and VPLS. The other 50% is related to triple play. And, in fact, we got a number two position in Europe, as I said, in IP routing. And you will have noticed we haven’t announced any big integration deals. So we’ve been winning this business on a basis of competition. In the labs competition, Ebay helped without router makers (phonetics).

We’ve now delivered to more than 100 customers in 40 countries, including over 20 incumbents, and we have shipped more than 5,000 routers now into customers. Your question on IP DSLAM. I think we’ve mentioned that our, we expect a number of lines to go up about 10% ‘05 to ‘06. And we would expect the percentage of IP DSLAM lines to probably about double ‘06 over ‘05.

A - Serge Tchuruk

If I may intervene before the next question. My colleague informs me that I have been too short on the satellite answer. So I am requested to tell you what it is all about. So, in terms of sales growth and operating margins, the so-called private communication group, which is PCG without satellites, without satellites we are talking about verticals and enterprise. So this PCG group without satellite is at the same level as the rest of our average, i.e. 7% on growth, and 9% on operating margin. Okay. Next question.

Operator

Our next question comes from the line of Richard Kramer with Arete. Please go ahead sir.

Q - Richard Kramer

Hi. It’s Richard Kramer with Arete. A couple of questions for various folks. First of all, for Jean-Pascal, can you give us a little bit more specifics on the free cash flow generation targets for 2006. If we assume there’s a roughly 220 million outflow for dividends and maybe 140 million or so of cash restructuring you were talking about, will you end FY ‘06 with a higher net cash balance, including those items, than you have at the end of FY ‘05? One for ether Serge or Mike, you’ve mentioned at several stages some investments with areas like spatial in mobile. And also we know you have a lower cost version of mobile infrastructure equipment coming out. Can you talk about why you wouldn’t necessarily see an improvement in profitability in mobile, and what your strategy would be going forward for 3G? And finally, one more question. We’ve heard quite a bit from your local carrier, France Telecom, about their CapEx outlook. Can you give us an update of where you stand with them in terms of projects for the coming year or several years and what you expect in terms of CapEx from that, one of your largest customers? Thanks.

A - Jean-Pascal Beaufret

Richard, cash flows, 2006 cash flow guidance. First of all, as you know, we start on reserves on the balance sheet of 471 million which we have to pay down in 2006 for an anticipated 230 to 240 million. This is one point of the future cash flow expectation in ‘06. Then, dividends are not at all out of the free cash flow. This is below free cash flow. So if we generate from operations what we believe is significant improvement in free cash flow after working capital, restructuring, CapEx and so on, then the net balance of cash at the end of ‘06 should improve versus ‘05.

A - Mike Quigley

Okay. Richard, I’ll, I hope I got all your questions there. I think the first question you asked was about operating margin in mobile for this year. As you know, in ‘05 we can as much as faster than the market, while we retained, in fact, a very good level of margin. We expect to grow, planning to grow at market rate in mobile in ‘06, but with more focus on preserving the margin. So it’s going to be a focus for us in 2006. And I just might add that like in Q1 in ‘05, we probably expect the margin in mobile to be below the 10%. In fact, we may see a little more seasonality, a little lower in Q1 in mobile. Probably up a bit in fixed. So we will see those quarter-over-quarter shifts. But we absolutely expect to put a continued focus on margins in ’06. You asked a question, I think, also on investments in spatial wireless. We’ve done, I would say, fairly well. I think most of you know we had a few bumps in the road as we were transitioning the products to the NGN product.

The good news now, the platform, the spatial platform has handled more than 10b live calls now worldwide. And it’s in fact being deployed in other places as well as T-Mobile, Mobile Comtel, China Mobile. So we’re now at a point where we’re comfortable with the stability of the platform and we’re taking it around the world.

I think your question on what we’re seeing with France Telecom and CapEx, the good news for us that we saw with the news from France Telecom was the potential of the Telecom (phonetics) and what they’re planning to do around their whole IP network transformation. As you might have noticed, we’re one of the pilot suppliers for France Telecom. And we see this as part of the overall picture, which is common throughout the world now, of big operators looking at transforming their networks.

Operator

Your next question comes from the line of Inge Heydorn with Deutsche Bank. Please go ahead.

Q - Inge Heydorn

Yes. Thank you very much. When I look at the key points you’re setting up here being increasing sales, focus on cash flow and OpEx, and then the guidance of the top-line growth and then a little bit cautious on the margin. Could you try to, it’s quite small guidance given you had quite a lot of room to act on the gross volume and then compete on spend and specific contracts coming out. But could you just give me some type of sense on where do you think the gross margin is heading, and especially on the fixed line? Are the quality of the products now falling away in terms of sales and the new products coming up? But is that going to affect gross margin positively, negatively, and what’s the type of leverage you have on the triple play products and IP products?

A - Mike Quigley

Okay. I’ll have a try with the question, which is quite complex. But let me just say a couple of things. First of all, in terms of the Legacy products, and you asked, I think, around the fixed area. We’re seeing in the Legacy area, there’s two main Legacy products. One is our ADM switching which, in fact, declined less than we had expected this year. And it is going to be obviously, as I say, 2005, it obviously is going to decline going forward.

And the other one, which was the opposite trend which is at CDM switching which, in fact, declined faster than we had expected it to, as Serge has mentioned. It’s now down to around 5% or less of Alcatel’s total revenue is in CDM switching. The question that I think you may be alluding to as well, if we see that shift towards IPTV, what will the margins look like in that area? What I can tell you is that we don’t expect to see any decrease in margins as a result of moving towards deploying IP transformation projects in IPTV.

A - Serge Tchuruk

Okay. If we look a bit at the recent history, I think the decline in gross margin did really happen at the end of ’04 actually. And we saw some erosion, particularly in ‘05. But if you discount the negating result, we had some erosion. I don’t expect ’06 should show massive change, massive decline, but we are also always cautious on the gross margin.

A - Mike Quigley

Of course, we, I think, are seeing some stabilization. We always expect to see some quarter-to-quarter variations as we do.

Operator

Our next question comes from the line of Remi Thomas with Cheuvreux. Please go ahead sir.

Q - Remi Thomas

Thanks very much. Congratulations on the results, especially the cash flow generation. That was quite impressive and quite a relief after Q3. I’ve got a couple of questions, if I may. The first one is on top-line growth, some questions have been asked before about large triple play deployments in Europe. We know that some of these are currently being held back because of regulatory constraint. In your current guidance for the full year, obviously slightly better than mid-single-digit growth, have you factored in any triple-play deployments or would you tend to revise that guidance upward should that regulatory issue be settled and some of the large incumbents in Europe start deploying? That’s my first question. My second question is regarding the succession of Serge Tchuruk. It’s quite unusual for a CAC 40 company not to know, just a few months before you’re expected to step down as Executive Chairman, who is going to be your successor. Can you give us some light as far as this is concerned? And also, perhaps, give us a timeframe of when you would expect your successor to be named.

A - Serge Tchuruk

Do you want to answer the succession one?

A - Mike Quigley

No. I’ll take the first one, Remi, and I’ll leave Serge to take the second one. In terms of the top line, clearly we’re watching very carefully what’s going on in the triple plays. And I say, if I can give you the guidance is that we have taken what I think is a very balanced view of what would happen, given what our experience has been in these regulatory issues, they sometimes take some time to resolve. But nevertheless, often operators, telcos, take a bet before everything’s completely clear. So what I would say, Remi, is, without going into specifics, we have taken a balanced view based on our judgment of what will happen in the fixed area.

A - Serge Tchuruk

In terms of succession, the timing is clear. By the June 1, I think, shareholders meeting, the Board will have the choice either to split the Chairman and CEO function. And if they do so and if they ask me to become Chairman, I will see what they do. Or they keep the President Directeur Generale, which is one single function together, or otherwise I would personally certainly disappear from the scene. In respect to succession, I have many, many months ago, actually May last year, clearly made my recommendation to the Board. It’s the Board’s choice. It’s not my choice. I read in the papers or the media that I am designating my successor. I am just making my recommendation to the Board.

Operator

Our next question comes from the line of Per Lindberg with Dresdner. Please go ahead.

Q - Per Lindberg

Yes. Thank you. I have a couple of questions related to the financials seen in the quarter and also with regards to the outlook 2006, if I may. First and foremost, it seems that you had a considerable revaluation of inventories and receivables in the quarter, 125 million if we read your footnotes correctly. Did that affect any of your income lines, gross income, operating income, net income, etc? And then the operating capital gain of 47 million, as extracted from the footnotes, equally, which income lines were affected or perhaps, equally relevantly, which expense lines?

And then finally, as far as the outlook 2006 is concerned, if we now summarize your four last quarters in terms of operating cash flow generation, we come to slightly more than 200 million, 1.7% of sales, on a par with your proposed dividend to shareholders. What is your outlook for operating cash flow margin this year if you, as we surmise, look for close to 10% operating income margin? Thank you.

A - Jean-Pascal Beaufret

So, several aspects of your question there. Just for inventories, receivables have gone up actually in the quarter, in Q4 ‘05, by 82 million just for ForEx, foreign exchanges impact. It had nothing to do with the P&L. It has not been booked at all in P&L. It’s purely assets and liabilities increases or decreases on the balance sheet, with no impact on P&L. Then, you were speaking about the capital gains of 47 million in the notes, which I don’t see. In the quarter, in Q4 ‘05, we have had 30 million capital gains which are booked in the operating profit, which are disclosed as such in your notes, and which come from the management streamlining of a real estate asset which we are continuing because the streamlining of our assets allows us to save money. And that allowed us to save a lot of money for several years.

Now, your third question was related to -- could you say it again, Per? Our ’06 margins?

Q - Per Lindberg

Which becomes very nicely in the last quarter, in the fourth quarter thanks to reversals of working capital there, inventory receivables. If our methodology works here, and we use of the same definitions as you do, we see then a total surplus from operations for Alcatel Group last year of 220 million. And that’s after working capital. That is on a par with what you propose now to pay in dividends. Now, and at the same time you have reported a 9% operating income margin for 2005. There is a discernible gap between these two measures clearly. How should we see these two financial metrics evolving in 2006 as you have highlighted now that you believe that the operating income margin will improve from the 9% level? I would like to know how you see the cash generation then progressing.

A - Jean-Pascal Beaufret

So, what we are saying for 2006 basically is we are working hard on improved cash flow generation from our results, first of all. Then we believe that we can do and still improve our working capital and have quite little outflows from our growth and from working capital next year. And third point, we believe that we can have a significant increase in restructuring cash outflows so that the free cash flow generated in ’06 will improve as from ‘05. The question asked on whether we distribute this improvement or not, but simply distributed for the dividends of ‘05, is a totally different question. We believe that we have all what it takes in terms of financial strength, balance sheet structure, so that we can remunerate our shareholders after four years in, from the last dividend in 2001.

Operator

Our next question comes from the line of Adnaan Ahmad. Please go ahead.

Q - Adnaan Ahmad

Hi. Yes. Thank you for taking my question. First of all, on SG&A, in absolute terms SG&A actually dropped sequentially, despite a 24% increase in your top line from the third quarter to the fourth quarter. Can you just take us through what accounted for that decline? And does that signal a trend for ongoing efficiencies in 2006, or was there something which was specific to the fourth quarter? That’s the first question. Second question, I have is looking at your outlook statement for operating profitability, you talk about a slight improvement in margin due to competition in some markets. Can you just elaborate on where you’re seeing these pressures from a regional as well as a business perspective and whether the competitive intensity has increased or decreased, or is at the same level as you have seen over the past 12 months? Thanks a lot.

A - Jean-Pascal Beaufret

SG&A is decreasing from Q4 2004 to Q4 2005, it’s what we are showing in our statement, from 496 million to 489 million. So there is a slight decrease of sales and marketing as well as SG&A costs. This is coming from basically our streamlining of the Company, our continued streamlining of the Company. And a lot of action has been made for several years and are continuing to be made just to retrieve our costs or fixed expenses. There is no particular reason. There is a lot of outstanding actions which are being implemented and we will continue to do the payment in 2006.

A - Serge Tchuruk

Mike?

A - Mike Quigley

Yes, perhaps I will take the second one. Your question was on how we see the competitive environment, different regions of the world and different product areas. I don’t know whether we’re seeing a shift in that occurring. I would say no, we haven’t built in any significant shift in competitive outlook in terms of pressure from competition. We see no reason why the environment’s changing at this point in time. In terms of the geographic spread, all markets are very competitive. Some are just competitive in different ways. Some customers have a bigger focus on boxes per se. Others want to get a broader value proposition which means there’s a lot of costs incurred in making sure we can deliver high value to them. So, all regions of the world we see competition. And, frankly, we see it across all product areas. And we don’t see any dramatic shift so far to ’06 in the competitive environment.

Operator

Our next question comes from the line of Ed Bell with Cazenove. Please go ahead.

Q - Ed Bell

Yes. Just coming back to the guidance of a slight improvement in operating margin in 2006. Clearly one would expect the optic sector, the business and the next generation wireless operations all to be showing a fairly healthy improvement in profitability in 2006. Could you just highlight which areas you expect margins to fall to offset that, to only show the slight growth in margin which you’re guiding Q on Q in 2006?

A - Serge Tchuruk

We do not necessarily see falling margins here and there. We gave the cautious guidance to give some on the back of this (indiscernible) but that’s what came out.

Q - Ed Bell

Okay. So you’re expecting mobile margins to stay at the level that they are in 2005?

A - Serge Tchuruk

We expect the margins in mobile to stay at exactly the same.

Q - Ed Bell

Okay. And secondly, just on your outlook for the second half, and talk of slightly slower growth there, is that only your nervousness about the mobile market which is causing that slight slowdown, or are you a little bit uncertain about the outlook for ’06 as well, or is it specifically a mobile factor?

A - Serge Tchuruk

No, the mobile is an issue. If you take China, the vision of the Chinese Government on the license wrangling is beginning to have a big impact on the marketplace. And today, nobody can get precisely when the decision to be taken, but on the (indiscernible). I know basically the regulatory environment in respect to fixed is also going to play a role, particularly in Europe.

Q - Ed Bell

Okay. Thanks very much.

A - Serge Tchuruk

Thank you.

Operator

Our next question comes from the line of Mark Sue with RBC Capital Markets. Please go ahead.

Q - Mark Sue

Thank you. I just had a follow-up question on some of your specific assumptions with 3G in China. Any thoughts on the number of licenses? Will it be three or four? The timing, will it be spring and of what timeframe? And for the potential share of TDS CDMA, do you think it can reach potentially 50%? And if we look at Alcatel’s market share, potential market share, how should we extrapolate your current market share in 2G into potential market share for 3G?

A - Serge Tchuruk

Okay. I wish I could give you a precise answer to your question because this is the sort of question we are reading to ourselves. If we look at what seems to be heard from the Chinese situation, one thing that is probable is that TDS CDMA will be launched. Timing-wise, there are also speculations that it might be launched even before the rest actually, eventually we made what is initially could be buying that project. We happen to be relatively well positioned by that because of, in addition to it and DTE, we have pulled up, frankly, which we are sending through the agreement. And the TDS CDMA story should not necessarily might play to our advantage. Basically, what we aim at is to get a market share in China on 3G, which is similar to what we achieved in 2G actually.

Operator

Our next question comes from the line of Alexandre Peterc with Exane BNP Paribas. Please go ahead.

Q - Alexandre Peterc

Yes. Hi. My first question would be relating to the gross margin again. Do you think that your gross margin is now where it is supposed to be, given the sector where you operate? And given that it is now lower, is that due to the mix? Is there anything you can do to reverse the current negative trend in gross margins? And what kind of focused measures you could take to get your margins to a higher level? And that’s excluding satellite obviously. I’m just talking.

A - Serge Tchuruk

Jean-Pascal, do you want to take that one?

A - Jean-Pascal Beaufret

Yes, why not? Alexandre, I would like to volunteer to answer your question about gross margin. We still believe that today we have a sustainable business model. This is clearly a very competitive environment. But we do believe that we have a sustainable business model, with services going up, with some equipment with higher margin going up, with some other businesses with margin going down. Then we continue to, of course, anticipate variations quarter-to-quarter because the business mix is changing, in geographies, in building equipment businesses or in sales and services. But we believe that we have a sustainable business model which allows us to sustain this type of margin.

Charlotte Laurent-Ottomane, Vice President North America Investor Relations

I think we will take one more question here before we end the call. Hello? One last question please.

Operator

Very good. And the last question will come from the line of Tim Daubenspeck with PacificCrest Securities. Please go ahead sir.

Q - Tim Daubenspeck

Yes, thank you. My questions are, I guess, for Mike. Just on the IP routing, the revenues in the quarter. You have a solid quarter last quarter. Were revenues up again sequentially for IP routing business in Q4? And then in terms of the 10% line increase forecast for DSL in 2006, can you help us quantify or give us an idea how much of an impact replacement lines are? You broke it out in the release. I’m just trying to measure new subscribers relative to replacement lines in terms of the DSL market in ’06. Thank you.

A - Mike Quigley

Okay. Tim, to answer your first question on IP routing, were we up in the fourth quarter sequentially? The answer is absolutely yes, and substantially. We saw, frankly, right throughout the year 2005, quarter after quarter, substantial growth rates. I’m not sure I have clear numbers I can give you on replacement versus new lines. But we clearly are seeing a mixture of drivers for our IP DSLAM business. One is just a ramp-up. And we’re also seeing migration now, which we talked about for some years, of the installed base. So that is happening. There’s probably not a sensible split I can give you between replacement lines and new lines off the top of my head. But perhaps we can get back to you on that.

Q - Tim Daubenspeck

But just to the routing question, thank you for the answer, but so you feel confident that you may have taken share again in the fourth quarter in terms of the EDGE routing market?

A - Mike Quigley

If the EDGE routing market took off the at the rate that we saw in the fourth quarter, I would expect yes. So we’re still, and as you would expect, Tim, and as we are an entrant over the last year or two into this business, we are taking market share quarter after quarter with a very good platform.

Q - Tim Daubenspeck

Great. Thank you very much.

Serge Tchuruk, Chairman and Chief Executive Officer

Okay. Thank you for your attention, and goodbye.

Operator

Ladies and gentlemen, this call will be available for replay later on today. You may access this replay by dialing 1-800-475-6701 and using the access code of 814297. International participants may also access this digitized replay by dialing 320-365-3844. And again, the access code will be 814297. Again, those numbers are 800-475-6701 and the international number will be 320-365-3844. Ladies and gentlemen, that does conclude our conference for today. Thank you for using the AT&T Executive Teleconference Service. You may now disconnect.

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Source: Alcatel Q4 2005 Earnings Conference Call Transcript (ALA)
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