Will Alcatel-Lucent Turn Its Fortunes Around?

Sep.17.12 | About: Nokia Corporation (NOK)

Alcatel-Lucent (ALU) is plotting its turnaround once again. It recently announced a management reshuffling as part of its previously planned cost-cutting measures. The company said that it will shift from its regional operating structure to global relevance in terms of business segments. The new structure will be composed of global products and operating business units: Core Networks, Fixed Networks, Wireless, and Platforms.

With this setup, Chief Financial Officer Paul Tufano is expected to take on the role of COO, while Robert Vrij will head up the Global Sales and Marketing Division. The result is a streamlined and dynamic management team that will address issues as soon as they arise. Even its executive committee has six fewer members compared to the 12 it used to have.

Recall how Alcatel-Lucent performed in the second quarter of this year. It reported revenue of 3.82 billion euros, down by 7.1% year on year. But this is up by 10.6% on a quarter-on-quarter basis. Revenue from the wireless business amounted to 877 million euros, an increase of 11.3% from the previous quarter. This is down by 18.7% compared to the same period last year. The decline in wireless revenue is due to delayed spending of service providers on 2G and 3G technologies. Despite this news, the company's LTE business experienced a threefold increase in revenue. In terms of geography, North America and Europe posted year-on-year declines of 8.3% and 15.6%, respectively. All geographies were up on a quarter-on-quarter basis.

This translates to a net loss of 254 million euros, narrower than the previous quarter's 398 million euro net loss. Management said that the tough macroeconomic environment and competitive pricing has taken a toll on the company's performance. The current environment has affected its competitors. Ericsson (NASDAQ:ERIC) also announced tough second-quarter results. Earnings per share have experienced a significant decline of 65%. While the company's Global Services and Support Solutions were strong, Network sales have declined from lower CMDA sales and weaker sales of GSM and 3G in some European regions. Another competitor, Nokia (NYSE:NOK), is still not out of the woods yet as it struggles to keep up with market leaders. It has also announced to cut jobs as part of its global plan to streamline its operations.

Management still believes that it has a strong position in most of its many attractive market segments like IP, next-generation optics, and broadband access. This offsets its wireless business as it faces strong headwinds, such as U.S. economic slowdown and greater competition.

With these developments, it introduced "The Performance Program" that will result in further cost reductions of 750 million euros. This will bring the total savings to 1.25 billion euros in 2013. The plan will include 5,000 job cuts in the organization, as well as the exit of unprofitable business segments. This is another attempt to improve its overall profitability. The company has previously reduced costs, as well as managed its product portfolio and working capital effectively. The company is targeting a strong positive net cash position by the end of this year.

U.S. Telecoms Need to Increase Spending

While cost cutting measures will improve profitability in the near term, this seems more like a band-aid solution rather than a long-term strategy. I believe that cost reduction measures have its limits. In the case of Alcatel-Lucent, it resulted in other restructuring and cost reduction efforts of the company. But I believe that Alcatel-Lucent needs to convince major U.S. telecom operators Verizon (NYSE:VZ) and AT&T (NYSE:T) to spend more on infrastructure. For this year, U.S. telecoms spent 17% less on infrastructure compared to the same period last year.

Verizon delivered strong earnings growth for the second quarter based on strong revenue growth and margins. But AT&T reported slower than expected revenues due to a weaker economy. Overall, telecoms will experience relatively tough results for the second half of this year.

Given the competition and uncertain environment, these telecoms are expected to spend less on infrastructure over the next few months. I believe that the Asia-Pacific region will drive the overall telecom infrastructure this year. The region needs to launch LTE networks, modernize its mobile networks, and carry out its national broadband initiatives. Since telecoms in Asia are also experiencing cutthroat competition, the operators need to invest in their network, or they'll lose significant market share.

For the last 10 years, Alcatel-Lucent has posted revenue decline of 4.92% a year. The company's growth rates have been relatively volatile. It has experienced decline of 2.11 year on year in 2011 following a 3% earnings growth in 2010. It posted operating margins of 0.8% in 20111, a reversal from the negative operating margin of 4.4% in 2002. It has negative operating margins for four consecutive fiscal years starting in 2007.

In contrast, Ericsson posted revenue decline of 0.22% for the same period. But it posted revenue growth of 5% for the last five years. This suggests that its strategy to improve its product line has worked over the recent years. It has operating margins of 7.9% in 2011, a turnaround from the negative operating margins of 14.6% in 2002. It is estimated to post $0.41 earnings per share, a decline of 25% year on year. But analysts believe it will grow its earnings by 8.50% for the next five years.

On the other hand, Nokia posted revenue growth of 2.16% for the last 10 years. But it has experienced decline in growth of 1.24% over the last five years. Its operating margins have significantly declined from 15.9% in 2002 to negative 2.8% in 2011. The company is forecast to post a loss per share of $0.41 this year, a decline of 207% compared to the prior year. Analysts are still bearish in the future, forecasting Nokia's earnings to decline by 1.30% a year.

Valuations

The stock is currently trading at 15.3 times forward earnings and 50% of book value. This is lower than the industry's average of 24.8 times earnings and 2.0 times book value. Investors are betting that Alcatel-Lucent will fail with its restructuring plan. In fact, these valuations imply a worst-case scenario for the stock.

For the last five years, Alcatel-Lucent posted negative free cash flow. The market will stay on the sidelines unless there's a big improvement on its cost reduction efforts. For now, I suggest investors to stay away from the stock and would only accumulate after it turns cash flow positive.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.