In Defense Of My $5 Price Target On Alcatel

| About: Nokia Corporation (NOK)

In response to my latest Alcatel (ALU) article in which I argued that ALU's stock price could very well multiply, I have received a few critical messages from some of my readers as to how I arrived at my price target of $5 on ALU over the longer-term and how a bullish thesis could be justified given that the company has posted declining sales and market shares since 2007. In addition, ALU posted net losses, sometimes significant, since 2007, not really being able to turn things around - though net losses declined steadily since 2008. Still negative operating and profit margins turn investors away. All of it seems to overwhelmingly speak against an investment in the company. After all, the company is in decline. But, not so fast.

Why buy Alcatel?

  • My general point is, I am holding ALU as a pure contrarian turnaround play as the company has lost the confidence of the majority of the investing community. Alcatel accounts for only about 3% of my personal portfolio with an average purchase price of $1.55.
  • Analyst average EPS estimates have increased 30% from $0.17 in 2012 to $0.22 in 2013 reflecting a tendency to more optimistic (or less pessimistic) forecasts. The company currently trades at a P/E of two.
  • I believe, that as a leader of innovation (see MIT link below) the company will continue to be at the heart of building digital infrastructure. Contrary to popular opinion, the company has not lost its edge, but only gotten a little bit behind, especially in Wireless and Optics.
  • My bullish thesis is particularly driven on ALU's engagement in South East Asia where demand, growth and potential is extraordinary and should play into ALU's hands.
  • As sales faltered, the focus of investors invariably switches to the cost structure and the efficiency of the company. ALU has substantially reduced overhead costs by $1 billion over the last three years with more cost reductions particularly in SG&A to come in 2012. Investors underestimate the impact of their own scrutiny: ALU has been under the microscope for years with analysts and investors demanding more efficiency in delivering competitive products and profitability. The company has followed up on this. In fact, I think ALU can be compared to AIG (NYSE:AIG) which made huge efforts in recapitalizing the company in 2011. Nobody at that time believed in its survival, except some hardcore contrarians who got in at rock bottom prices. As a result, I am convinced the company is allocating resources the right way laying the path to a turnaround, even though it will take time.
  • ALU has an interesting IP portfolio and posted good y-o-y revenue increases which shows that the company is gaining ground.
  • Wireless and Optics have been pretty bad for ALU, but I judge this to be a fixable issue in the mid-term for the company - the company is focusing on the issue.
  • The entry into the new internet router niche market with the new 7950 XRS could give the company much needed momentum
  • After all, the company is learning the right lessons and moving in the right directions.

I put ALU in the same basket as I did other distressed investments that I rode over the years. The thesis: A continued decline in the share price and a prolonged phase of pessimism and negative results leads to a severe mis-pricing at some point, one which offers a significant margin of safety. I believe this point is reached - the company trades at only two times earnings. Investors, in general, oftentimes are emotional about their investments. The overwhelmingly emotional responses to my short thesis of mortgage REITs, indicate the emotional attachment many investors exhibit with their stocks. Investors disregard information that contradicts their beliefs and are, more often than not, subject to confirmation bias where they look for confirming evidence. I judge emotional investing to be the number one enemy of any investor.

ALU is one of those stocks that receives constant bearish evaluations where investors extrapolate negative results and push the margin issue. It if often argued, that margins are too low or even negative. ALU counters this development by making the cost structure leaner, pressing SG&A, and recently sold Genesys for Euro 600 million to increase cash and provide financial flexibility -measures that are characteristic for mis-priced turnaround investments. In my opinion, is the right thing to do.

I believe that the general investment community has gone way too far in writing off Alcatel, a company, that, still, has been around for some time. It purportedly has lost its edge, like Research in Motion (RIMM), which I also consider a great turnaround candidate. I do not believe that a company such as RIMM or ALU that have dominated and defined an entire industry, are just going to be wiped off the map. If a company, such as Alcatel, has just been selected by MIT's technology review to be one of the 50 most innovative companies 2012 in its field, it is difficult for me to follow the herd and believe in the fall of this company.

Both stocks, RIMM as well as ALU, are subject to criticism for so long, that I consider the downside limited. On the other hand, the upside can be enormous. Once a company works itself toward a catalyst, expectations and valuations are going to change rapidly. I am convinced that ALU is terribly undervalued based on margin fears and reiterate my opinion, that Alcatel could very well prove to be a multi-bagger. I have an earnings estimate of $0.42 for 2014 on the stock. With a multiple, still depressed, of only 12, the shares would have a target price of close to $5. I also believe that the company has finally found its bottom.

Opposing views are welcome.

Disclosure: I am long ALU, AIG.

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