Alcatel Q1 2006 Earnings Conference Call Transcript (ALA)

Apr.27.06 | About: Alcatel (ALA)

Alcatel (ALA) Q1 2006 Earnings Conference Call April 27, 2006 1:00 AM ET

Executives:

Pascal Bantegnie, Vice President, Investor Relations

Serge Tchuruk, Chairman and Chief Executive Officer

Jean-Pascal Beaufret, Chief Financial Officer

Mike Quigley, President and Chief Operating Officer

Analysts:

Robin Nazarzadeh, Citigroup

Tim Long, Banc of America Securities

Alexandre Peterc, Exane BNP Paribas

Mark Sue, RBC Capital Markets

Jeffrey Schlesinger, UBS Warburg

Ed Bell, Cazenove

Remi Thomas, Cheuvreux

Richard Kramer, Arete Research

Paul Sagawa, Sanford Bernstein & Co

Eiji Aono from Credit Suisse

Francois Duheim(?) from CMCIC Securities

Tim Daubenspeck, PacificCrest Securities

(Peraz Ferrar?), BMO Financial Group

Per Lindtorp, ABN Amro

Operator

Ladies and Gentlemen: thank you for standing by, and welcome to the 2006 Q1 earnings release conference call. Operator instructions. I will now turn the conference over to Pascal Bantegnie, please go ahead, sir.

Pascal Bantegnie, Vice President, Investor Relations

Thank you. Hello to everyone. With me today are Serge Tchuruk, Alcatel's Chairman and CEO, Mike Quigley, President and COO and Jean-Pascal Beaufret, CFO. We'll discuss today's announcement of our Q1 2006, and give you an update on our outlook and guidance. I would like to let you know that today's call will focus on Alcatel's Q1 earnings only, we will not discuss the upcoming merger with Lucent technologies, nor our industrial partnership with Thales. We appreciate your understanding on this.

Our slide presentation can be found on our website, the presentation will be followed by a Q&A session. Before we begin, I would like to remind you that certain statements we'll be making today may be considered forward-looking. Please refer to the Safe Harbor statement contained in today's releases. I will now turn the call over to Serge Tchuruk.

Serge Tchuruk, Chairman and Chief Executive Officer

Thank you, Pascal. Before we start, I know that we are not going to talk about the merger between Alcatel and Lucent: let me just say that the reaction in the Alcatel organization was quite positive, and we have singled out a few people who are going to work on the merger. Most of the organization will focus on making our numbers for the quarters to come. On the other hand, our plans to transfer satellite and security access to Thales will allow us to reinforce our industrial partnership and will open new opportunities for communications technology in the defense and security market. As a consequence of those two projects, our annual shareholders meetings has been rescheduled to September 7th. We'll propose a dividend of €0.16, at the forthcoming meeting.

Turning to the Q1 results, as you can see from the chart, which is chart page three, we had a strong quarter in this seasonally low Q1. Generally we have a dip in our activity, but we did manage to get a big increase in our revenue, as you can see, 18% with revenues reaching €3.1 billion. This is a result of a relatively good market, but also the fact of our strategy of focusing on solutions, whether it's on triple play or even on the mobile networks, it's already paying off. We had an operating profit of close to €200 million, which is 6.5% return on sale, which is a big increase compared to last year - 85%. Net profit, €0.08 per share, comparing to €0.09 last year. The €0.08 this year does include €0.02 of capital gains, last year our €0.09 did include €0.05 of capital gains, so excluding the capital gains the diluted EPS went up by a significant amount: €0.02, which is close to 50%.

The net cash was recorded at €1 billion, which is €700 million more than last year, meaning we have good control of our cash situation. Looking at the segment analysis on the next page, we had a very strong performance in fixed communications, with revenues close to 30% up. Operating profit more than doubled from €50 million to €110 million, with a margin of 8.6%. This is primarily growth driven by a strong quarter in access, and a sustained strong performance in our IP activities, which I will detail a bit more in a short while. The profitability is on the high side. I think we never reached this level of profitability on fixed communications in this very seasonally low quarter. On mobile, a strong increase in revenue of 15%, driven by growth in all radio technologies spanning from 2G to HSPDA and in all regions, actually, coupled with Euro(?)-sustained rapid growth in applications.

Concerning profitability, mobile networks as you know is operating in an intense competitive environment. In addition, we have consequently stepped up our investment in R&D and marketing, geared at next generation technologies. Our margins came up at 6.3% in the quarter, at a level of €48 million. Private communications, we saw revenue growth there also, regaining revenue growth in all segments except space, which is still affected by the late commercial order intake in the previous year. The growth was quite strong in integration services activity and enterprise, primarily led by IP telephony.

Looking a bit more into some more detail by segments, in fixed communications the IP transformation of carriers' networks to provide triple play services continued to drive growth during the quarter. We had a number of contract wins, like in Italy, Denmark, Slovakia and China. To be underlined, a solid performance in access in the quarter practically in all technologies. We shipped 6 million DSL lines, which is 50% up year on year, which conserved the trend which we had been showing at the end of last year. We also held strong on the so-called IP DSLAM, with something like 90 customers now having adopted our product offering. On the IP service router revenues, we registered a ten-fold year on year increase compared to last year, confirming the number two worldwide market position in IP integration, and we're sharing the number one position within Europe.

Optical networks driven by the bandwidth requirements linked to video, among other things, were sustained, and there also we had some significant growth showing up including the submarine sector. The NGN/IMS solutions business turned an encouraging level of performance which registered (some of our work here and there?), but in one IMS project in the UK. But substantial revenues are coming due comparing(?) next year. The TDM voice continued to decline at the rate of about 30% per annum. Looking at mobile communications, we have continued growth although it is slowly down a bit from what it was in the quarter before, but the momentum is still strong in our next billion subscribers strategy in the emerging world, as well as in our application offerings.

We are present in all radio technologies, 2G, 2.5G, 3G, HSPDA and we still today will see that start of 3G in some of the emerging world countries, which offers a big market to come. I should underline the fact that in video applications, we have now reference in the mobile field in 80 accounts, and something like 20% of worldwide mobile video users are using Alcatel technology. We have stepped up investment in NGN/IMS, in product share in 3G and WiMAX. To talk about WiMAX, we have been one of the early investors in this technology and we are now showing some real strength, with new wins in Russia and Japan. We are launching a new WiMAX base station, which is going to be ready for commercial activity in 2H06.

Having said so, the competitive environment is rather intense, with pressure on prices, but we are still stepping up our efforts in the NGN/IMS core switch, where we do believe our ATCAB8(?) platform has remarkable strength in the markets to come. Now, on Private Communications, the enterprise, we had a strong quarter in IP telephony and applications. We are number one in the world and to a good extent in Europe in IP telephony. The transport signaling activity remains solid, and we've registered a number of new contracts. Also quite healthy was integration services, which showed a good performance once again, driven by opportunities in the transport and energy markets and also in the OSS space. The space business declined slightly, but we see now some pick up in the order after a lull of about 18 months or two years.

Next slide, by geography. To be noted: the year on year variation in local currency, which is a real way to measure what's happening in the marketplaces, North America went up 50%, which is a big move forward, driven by access and triple play. Now North America, which was only 14% of our revenue last quarter, is now 20% which is more in line with (inaudible) at the beginning of last year. Western Europe also did well, with 11% revenue increase, as did also the rest of the world. Asia-Pac was on the weaker side, although we did record a double digit increase in China, to a large instead leading to the need for wireless communication there. That's the picture of what we recorded in Q1. Jean-Pascal will now give you more details on the financials. Jean-Pascal?

Jean-Pascal Beaufret, Chief Financial Officer

Thank you. Let me start at page 10 with a few comments on the profit and loss account. First of all, with €3.067 billion sales, revenue expansion was high at 17.6%, including a 2.7% positive impact of the average increase of Euro-Dollar rates year on year. Gross margin came in at 34.9%, and they are stable over the last three quarters ending March 2006. No BDG(?) impact recorded in Q1. In FY05 we brought in gross margins of over 35%. We today believe we have a sustainable business model in the competitive environment. We continue to anticipate variation quarter to quarter depending on this environment. Operating margin came in at €198 million, and grew by €91 million including a €28 million capital gains on the disposal of real estate in Europe. I'll come back on that in a minute. Backing out all specific items, operating margin still improved over last year.

Operating profit improvement results basically from the strong leverage effect, with fixed expenses to sales ratio down 4% in terms of percentage of sales, from 32% in Q1 2005 to 28% in Q1 2006. This is a real improvement, given that we've continued our investments in key technologies and markets, OPEX came in at €872 million, it grew 3.6% as a result of significant R&D additions, some additional selling and marketing expenses, and well as Dollar-Euro rate impacts. Restructuring at €25 million in the quarter were at line with the full year estimate which is around 1% of sales. Page 11, we see net financial income, expenses in the quarter of €45 million, resulting from recurring charges such as carrying cost of debt, financial components of pension costs and currency adjustments. Comparing to Q1 2005, where we moved €68 million of capital gains, we did not record any finance(?) related capital gains in Q1 2006. Net income from equity affiliates are basically a profit in the quarter of €5 million. We do not see any material loss going forward from equity affiliates.

We booked a net tax charge of €40 million, in line with the quarterly results, at a 12% rate of net income before tax. Going forward, we maintain our estimates of a tax charge for the year in the high end of the 10-15% range. Income from discontinued activities - we didn't dispose of any activities in the quarter, but as mentioned in our notes to our statements, minor positive or negative adjustments for ongoing legal proceedings were related in this quarter to back disposals. We came in with an EPS of €0.08, and as Serge said, this EPS includes €0.02 of capital gains, where it included €0.05 of capital gains in Q1 2005.

Page 12 is for your information and for the sake of your modeling. This table provides the total impact of sale variation changes in our bid hedging position as well as the outcome of (real inaudible deals?) that impacted both our current and prior years' operating results. Going forward, and on a full-year basis, our assessment today is that at the operational level, we may book a similar amount of capital gains as last year, that the count in our reported FY05 operating margin for €52 million. This results from the strong management of our real estate assets. Backing out all the specific items, we've seen our operating margin significantly improving from 5-5.6%, showing the best margin performance ever in Q1.

Coming now to balance sheet items on page 13, I'd like to mention that operating working to sales ratio at 6.9% is maintained at a fairly stable level quarter on quarter and is in line with seasonal patterns. Inventory level increased from last year by €273 million. Typically, as you know, Q1 inventory levels recover from the significant destocking level they reach at the end of each fiscal year, and this is linked to strong sales during the quarter in Q4 and building inventories mean that we see good revenue growth within the next quarter on a quarter to quarter basis. Inventory turns improved year on year significantly. Receivables reduced sequentially and all the more that in addition we factored receivables in the quarter. Going forward, we maintain our 5-10% operating working capital target, having said that we see of course we cannot discard variation quarter over quarter, and depending on the business seasonality and geographical mix, it may in a given quarter result in averting(?) working capital going beyond that range. But we believe that we should keep it at the 5-10% range overall.

Coming now, page 14, to the net cash reconciliation of the quarter, I'd like to mention that overall free cash flows improved since last year by €71 million, at €479 million to €408 million. This is stemming from additional cash operating profit of €76 million which highlight the quality of earnings in Q1 2006. This stems as well from reduced restructuring cash outflows of minus €49 million, this stems from the same operating working capital and non-operating working capital outflows as last year, including the disbursement of non-operational compensation related cost and VAT taxes. This has been partially offset by interest in taxes and some additional CAPEX. We therefore confirm our target of an improved free cash flow for the full year, and expect the rest of the year to follow the same trend as that of 2005.

Going forward, we should see the CAPEX amounts slightly up in 2006, but only slightly, just in order to build some testing equipment and a proof of concept lab. One more point on the cash flow: we have had acquisition in this quarter and we've seen in the acquisition a disposable (blind, a two-one acquisition?), partially offset by the sales of real estate. Lastly, page 15 shows the usual balance sheet numbers which are pretty straight forward therefore I have nothing specific on that. I would like to now return it back over to Serge.

Serge Tchuruk

OK. As a quick conclusion, some comments about the outlook. At the end of the year, we said the market growth would depend to some extent on some outside factors, like the FTTx regulatory outcome, or the Chinese 3G license situation. Nothing much has happened on the FTT regulatory outcome, but in Europe or Asia or Asia-Pac, it is still a pending issue but things are progressing slowly. On 3G licenses in China, they have been deferred once more but we do hope that by year end they should be unblocked. Not to the point though to generating even revenues in 2006, so I think the bulk of the revenues should show up in 2007. We also said that the market would, to some extent, depend on the (ticker parade?) of IP network transformation. On that standpoint the news is rather encouraging, we see most carriers really tackling the issue.

All things being considered, we are not changing our guidance on the carriers market, which we still see to be around the mid single digit for the full year. We are still quite convinced that Alcatel will once more do better than the market, so our growth should outpace the market this year again. For Q2, we see our growth in the mid to high single digits, as we had said earlier, with no change from whatever we guided earlier. Also for the second half, we guided on growth, which is lower in the second half than it is in the first half compared to the year before. Basically, because the year before second half was stronger than the first half. We had rather strong sequential growth last year for the second half. That's a bit where we see ourselves in terms of volumes, and activity in sales.

In terms of margin, there is no doubt that the market is very competitive and I think a number of our competitors have said the same thing about it. But we do concern(?) a slight improvement in our fiscal year operating profit margin, where we said last year it was 9.1%, we are not changing the guidance there either, we think we should see a slight improvement this year. Overall, we are still very much focused on improving the quality of the earnings, and as Jean-Pascal stated, we are expecting a significant free cash flow generation this year again. So that is where we stand, and Mike and Jean-Pascal are ready to answer your questions with myself, also. Thank you.

Questions and Answers

Operator

Operator instructions. Our first question will come from Robin Nazarzadeh from Citigroup. Please go ahead.

Q - Robin Nazarzadeh, Citigroup

Hi, thank you very much. My question is on product mix in the six divisions. Despite the strong revenue number you posted, I think that some were perhaps expecting a better margin number. We've seen similar revenue numbers posted in the second and third quarter of last year, indeed with a better margin results for the six divisions. I was wondering, especially when considering that you've seen a very strong quarter for optical and IP routing and switching, what could have driven a better margin for the quarter? What can we expect in terms of product mix to see an improving margin over the course of 2006? And would I be correct to sort of interpret the following: that the weak margin in mobile should be extrapolated over the course of 2006, and if that is the case and if we were to stay in the framework of your group margin guidance, that we would in fact have to see a fairly decent improvement in fixed line margins over 2006? Thank you.

A - Mike Quigley, President and Chief Operating Officer

Robin, I'll start, and perhaps Jean-Pascal might like to add something. As Serge said, this is in fact the best result we've had in the fixed group in Q1. We traditionally have a lower position, lower result in Q1 so this is both a good volume in terms of revenue and a good operating profit that we've seen. The areas of strength that we had were in optics, as you said, were in IP and just to repeat something said earlier, we've seen our IP business now really start to climb. It's gone up tenfold year over year, from Q1 last year to Q1 this year, and the MS WAN has stayed in a reasonably healthy state. Likewise our access business has been strong once again in Q1. I think what you're seeing in here is a stronger Q1 than we normally have in fixed. We have no reason to think that a strong mix affects one way or the other, it's just the traditional business and we expect the full year to keep going as per usual. Jean-Pascal, if you want to add anything else?

A - Jean-Pascal Beaufret

(inaudible), there is a slight improvement for us in the mix and in the margin, which will continue this year.

Q - Robin Nazarzadeh, Citigroup

And is it correct to assume that mobile margins will actually be lower than 2005 for full year in 2006? I guess in the past you've guided for margin preservation. Should we be thinking differently about that in light of Q1 results? Thanks.

A - Mike Quigley

I think it would be fair to say, Robin, that seeing the competitive pressure in the marketplace that we're seeing, as Serge mentioned, our competitors are looking at the same sorts of situation. I think it's probably fair to say that this year in 2006 the margins are under a little more pressure than they were last year. We'll of course be redoubling our efforts to try and make sure we get cost reductions in place faster, but nevertheless what you say I think is an accurate view, that competitive pressure makes it a bit tougher in mobile this year than last year.

Robin Nazarzadeh, Citigroup

OK. Thanks very much.

Operator

Our new question comes from Tim Long with Banc of America. Please go ahead. Tim Long, your line is open. Please go ahead.

Q - Tim Long, Banc of America Securities

Hi, just a question on the IP edge side, you talked about a 10% YoverY increase in the revenues there. I'm assuming that's kind of flattish sequentially, so if you could just clarify that and talk to what you think your market share did sequentially? Then on the 7710 SR, the new product you have, you talked about one new customer in New Zealand I think in the press release. Could you just talk to use a little bit about what you think the opportunity could be there? And whether or not that could yet add another level of growth to this business? Thank you.

A - Mike Quigley

OK, let me take that. First of all, I need to just say maybe wasn't clear enough there. It wasn't a 10% growth, it was a ten times growth, and I'm talking about here Q1 2005 to Q1 2006, so that's a ten times, multiplied by ten. That I think gives you an indication of the rate at which we are picking up market share. The latest inputs we have on that in fact is that we've established now clearly I think the number two player position worldwide in IP edge aggregation and in fact the number one share position in Europe. The reports that we saw from the industry analysts came out as a growth in 25% market share in Q4 of last year. Of course, we don't have the Q1 market share numbers from the industry analysts at this point in time. We're certainly continuing to gain momentum. We saw in Q1 another 25 new wins in our IP routing space. And you mentioned the 7710 SR, that's in fact an expansion of the range of the edge. It's a small POP version of the 7750, so it's got exactly the same feature parity as the 7750 and it's really about filling out the range and addressing mobile and also emerging countries. So yes, we expect to see some wins come from that, and the one we mentioned in the press release is just the first. This has only just been released.

Q - Tim Long, Banc of America Securities

OK. Am I correct then that those revenues were flat sequentially, or close to flat?

A - Mike Quigley

You're talking QoverQ from Q4?

Q - Tim Long, Banc of America Securities

QoverQ, yes.

A - Mike Quigley

I'll just look at the numbers here for you, I've got them handy.

A - Jean-Pascal Beaufret

No, they were sequentially up.

A - Mike Quigley

Up again, yes. Up again.

Q - Tim Long, Banc of America Securities

OK. Can you share by how much?

A - Jean-Pascal Beaufret

No.

A - Mike Quigley

But in fact if you see the industry, this is a market that is, in fact, increasing, so if you look at the industry analysts reports, you will see in fact our market share climbing in quite a number of the ranges, so you can extrapolate the growth rate from that.

Operator

Our next question comes from Alexandre Peterc, from Exane. Please go ahead.

Q - Alexandre Peterc, Exane BNP Paribas

I just have a question, if you could clarify a little bit what is going on in R&D, specifically in NGN/IMS. Is the action platform still incurring higher costs there than what you'd expect typically? Overall, SG&A and R&D, both quite substantially higher than what I thought, so if you could just shed a little more light on that? Then the second question would be with respect to the mobile infrastructure marketplace. Can you explain what's going on? Who are the fiercest competitors, is it still the Chinese, is it some of the other players? With everyone dropping in margins by 3-5% if you look at the year on year operating margins of the biggest players, is this sustainable, will it worsen? A bit of outlook there? Thanks.

A - Mike Quigley

If I first of all tackle, Alexandre, the question on IMS/NGN, yes we are continuing to maintain a strong effort in 2006 on NGN, we just believe it's the right thing to be doing to continue to put R&D in there. As you know, we had to pump a bit more money into 2005 to our mobile NGN, and we've also continued to invest in WiMAX. We think this would be the wrong time to back off R&D efforts at this point in the marketplace. So we are continuing to spend money R&D in mobile NGN and in WiMAX and in making sure we fill out the range.

A - Jean-Pascal Beaufret

On the price competition, your question is who is pressing a lot on prices. Today one of the largest players on the scene who has been losing market share has been the most active in depressing prices. I hope this is not going to last forever and I do believe it cannot last forever.

Q - Alexandre Peterc, Exane BNP Paribas

But I guess the question is, do you see other players as well joining in and all pressuring prices, or is it just the effect of one player? And where are the Chinese?

A - Jean-Pascal Beaufret

The Chinese are still around, but the Chinese are not always the most active in depressing prices.

Alexandre Peterc, Exane BNP Paribas

OK. Thank you very much.

Operator

Thank you. Our next question comes from Mark Sue with RBC Capital Markets. Please go ahead.

Q - Mark Sue, RBC Capital Markets

Thank you. Can you just update us on key projects such as Telstra and the ramp at AT&T, and maybe also Deutsche Telekom? And should we assume that wire line bookings are actually strengthening and may actually offset some of the wireless weakness toward the back half of the year?

A - Mike Quigley

First of all, let me say if I take those projects one by one as you mentioned, on Telstra as you know there is still a regulatory debate going on in Australia. We have just to remind you, been chosen as the fixed network integrator supplier for Telstra and we are filling out their network with the exception of the fiber to the node technology, which is subject to the regulatory outcome. We are keeping our fingers crossed that that outcome will be positive. I personally believe it would be a real pity if Australia didn't have the opportunity to enjoy high speed broadband so I expect a solution will be found. On AT&T, I think you heard from the AT&T(?) call in just the last couple of days, that the project is proceeding as we said all along, it's a complex project, it's really going to produce a new type of video products completely. It's going as well as we could expect it to. Likewise, in BT that project's moving along as well. So I'd refer you back to those customers. We probably shouldn't say too much more than that. On the wire line picture overall, it is certainly we're starting to see in some markets a bigger investment in wire line in terms of growth 2006 over 2005, in wireless, which is the first time we've noticed such a trend for many years. I think there's going to be continued investment in wire line as Serge mentioned, as we're seeing IP transformation projects going on, as we see the IP TV happening, and as ultimately we see IMS coming into play in 2007 and 2008.

A - Jean-Pascal Beaufret

(inaudible) what Mike just said, that we had a book to bill ratio well above 1 in Q1 actually.

Operator

We'll now go to the line of Jeffrey Schlesinger of UBS Warburg. Please go ahead.

Q - Jeffrey Schlesinger, UBS Warburg

Thank you. Two questions if I could, one to Jean-Pascal. Could you give us a sense on the SG&A which was up sequentially despite the 20%+ sequential drop in revs(?). What should be expect going forward here? Is this a new run rate level, and what should we look for here sequentially in Q2 given the very high level starting out? And for Mike, when you talk about the competitive pressure in mobile, did you see degradation in your gross margins as you would expect given the price competition? Or give a sense of how much came out of the op ex absorption for investment versus gross margin compression? Lastly, can you give us a forecast for DSL port shipments this year, as you typically do? Thank you.

A - Jean-Pascal Beaufret

Yes. Overall cost, Jeffrey, went up 3.6% in the quarter, taking into account capital gains on one hand and capitalization of R&D. If we let back now and look at disclosure in terms of SG&A, SG&A went up significantly because we've booked the capital gains in SG&A, but you have to take account of the dollar impact on cost as well. So all cost has been negatively impacted by significant changes in Euro-Dollar rates by 4% for the SG&A. Which meant that in Q1 2006 SG&A went up by 2.7% there since last year, Q1 2005. What we see going forward we will not guide on cost, we guide on operating margin, and we see a slight improvement of operating margin. We are absolutely targeting to capital cost and to continue or cost reduction and cost efficiency programs, and we'll do so, so that the impact of that on selling and marketing expenses and overall on administrative and general expenses will be reduced to let's say a slight increase.

A - Mike Quigley

OK. Let me address I guess first, Jeffrey, the question you had on - take it backwards - on DSL. Just to remind you again, we shipped 6 million lines in Q1, which was up as Serge said well above 50%. We did 3.9 million in the same quarter last year. What we expect the market to do it to grow roughly 10% in volume in 2006, which would probably put the market around 70 million lines or so. We expect to increase somewhat our market share again in 2006, as we had a bit of a down, as I mentioned several times before, in 2005 because we did not focus so much on remote ATM DSLAMs and we're now seeing a real pick up in IP DSLAMs and as we start to push our with fiber to the node, fiber to the curb, we're seeing more IP remote DSLAMs which we're in a very good position for. So we expect to pick up market share in 2006 and we're finding that our IP DSLAM range is now picking up real well with more than 90 customers. On the competitive pressure in mobile, obviously in competitive pressure we see it in prices, so as Jean-Pascal has just said, we need to keep up the effort on cost reductions so that the impact on the overall margins on mobile happens both on the pricing level, of course, and the fact that we are making the investments as we spoke about in the op ex numbers in both sales and marketing and in R&D.

A - Jean-Pascal Beaufret

If I can just add, Mike, we are going to market in 2H with a new architecture for our radio product, which is far less costly than the former ones. So we should start impacting our margins this year.

Jeffrey Schlesinger, UBS Warburg

Thank you.

Operator

Thank you. Our next question comes from Ed Bell of Cazenove, please go ahead.

Q - Ed Bell, Cazenove

Yes, just another couple of questions on the mobile margins. You were sticking to your margin target of 10% for mobile infrastructure margins quite late in the quarter, despite the comments from Mark Rouanne in Barcelona, which were fairly bearish. Was there something that happened late in the quarter which is making you now change your guidance, or is it just that you're seeing the impact from profitability across the industry? Then secondly, a sort of bigger picture thing, can I ask what flexibility you've got in some of these R&D projects? If we see wireless competitive pressures continuing to mount, what sort of flexibility have you got to back off those investments, or I suppose what's a minimum level of acceptable margin to you in that business?

A - Mike Quigley

Let me take a shot at this, Ed. Let me start with the last question, the flexibility in the R&D projects. Of course we have a large degree of flexibility, and this is always in R&D a trade off between the short term and the long term. You can throttle back on R&D but then you've got to look at the implications that would be. Frankly, I don't think it's a question for us of throttling back on R&D. I think it's a renewed effort on cost reduction and as Serge had mentioned, I think the industry will shake itself out to some extent that we won't be seeing this tough pricing environment forever. It will always be tough, because we always have it in this industry, we're constantly cost reducing. But hopefully it'll become a little more rational. So we have a lot of flexibility, but that's not the area that we would want to exercise. It will be beyond redoubling the efforts I believe on cost reduction, on overhead costs. Not so much on R&D. In terms of the former part of your question, we're just constantly looking at where we think the market is trending and what we're seeing on prices. Of course, you always get a much better picture as you sum up the numbers at the end of the quarter. So that helps you to do that. Jean-Pascal?

Q - Ed Bell, Cazenove

In your guidance or your expectations for the year, are you expecting pricing pressure to ease in mobile toward the second half?

A - Mike Quigley

No, I don't think that's the case.

A - Jean-Pascal Beaufret

No, but we should have a lower cost offering.

Q - Ed Bell, Cazenove

OK. Thank you very much.

A - Serge Tchuruk

And then I probably should add the comment that we are discussing here and there a few tenths of a point of margin, actually. I don't want to talk too much about the Lucent merger, but you know what we have at stake there is a cost impact which would translate into an upgrade of the margin of seven points, actually, the orders of magnitude are completely different. So we are talking obviously to monitor our own business with (this margin?)

Operator

Our next question comes from Remi Thomas with Cheuvreux. Please go ahead.

Q - Remi Thomas, Cheuvreux

Two questions, if I may. On the first one, I'm trying to reconcile the achievement you've made in Q1 in terms of operating margin, which on a clean basis, basically increased by 50bps, with the target you have for the full year. If I look at the mix shift going forward, we should expect more growth in fixed, which happens to be more profitable. Are you guys concerned that some of the price pressure that you're currently seeing in mobile may actually reach some of the segments in fixed as well? And if that's the case, could you tell us which segments might be affected by price pressure? My second question is on China. You mentioned in the introduction you had a 10% increase if I understood you correctly, whereas Asia-Pac revenues were down 1%. Can you tell us how you achieved this, given that Lucent's numbers, your merger partner, weren't that great?

A - Mike Quigley

I'll take the first one, Remi. I think your arithmetic there is correct in terms of 50bps, is what we see has gone up. The question I think fundamentally you asked, is do we expect to see competitive pressure in the fixed area. The answer is, I think frankly, yes. I think we're going to see continued competitive pressure, but we have been subject to that in a range of products, in optics, in access, for some time. We now have, in fact, a very good position, both in technology and our ability to put end to end solutions together in the fixed domain. We have, frankly, an unparalleled product range in that area, and a demonstrated capability to integrate. We are also seeing, as you probably detected from our IP numbers, an increasing position in that space which should also help us in the margins, but overall to answer your question, do we expect to see continued and perhaps even slightly stronger pressure in competitive pressures in fixed; I think the answer is as that market grows, yes.

A - Serge Tchuruk

China. I'm sure you've looked at what Lucent told about China, but basically we are not on the same products. The market on GSM in which we are a key player was pretty strong, and even stronger because of 3G being delayed. Part of the needed capacity had to be filled by 2G investments. I believe in the case of Lucent it's more linked to the PHS and PDMA situation in China which is different.

Remi Thomas, Cheuvreux

Great. Thank you.

Operator

Thank you. Our next question comes from Richard Kramer from Arete. Please go ahead.

Q - Richard Kramer, Arete Research

Hi, thanks very much. A couple of questions for Jean-Pascal, then for Serge and Mike. Jean-Pascal, can you help us understand the €248 million negative move in the cash flow and other current assets? Also, perhaps you could let us know, since you mentioned space within private was down, was this business, since it was around breakeven last year, was this business at a loss in the quarter? Then finally, can you help us understand at all the impact of provisions as you lay out in note 15 how they might have impacted some of the different divisions and whether there is one division or another within operating income where there was a particularly large impact? Then some questions for Mike and Serge, this IP growth - were there any single large purchase orders in the U.S. that contributed to that with specific customers or in other markets? Then, more broadly, given that you share customers and customer bases with your future merger partner, is there any risk looking forward that there is some delay in purchasing from those customers until your roadmaps are clear and you've made some selections in switching our transport in some other areas? Which product areas will be taken forward in favor of others? Thanks.

A - Jean-Pascal Beaufret

Richard. About the cash flow questions, what are the cash disbursements of other working capital variances, it's what I commented on slide 14. Basically we have seen in Q1 2006 the kind of accelerations of early disbursements into the non operation compensation related costs and VAT taxes. And these explain most of the €248 million you mentioned. You had another question about private, could you say it again please?

Q - Richard Kramer, Arete Research

Yes. You mentioned that the space business sell in Q1 was down slightly. Was this business actually at a loss in the quarter?

A - Serge Tchuruk

The answer, Richard, is no. There's still a small margin.

Richard Kramer, Arete Research

OK. Thanks.

A - Jean-Pascal Beaufret

Then you had a question about reserves. And the decreasing reserves and the way the reserves have flown through the P&L, is this right?

Richard Kramer, Arete Research

Yes.

A - Jean-Pascal Beaufret

We have had restructuring reserves down by €65 million out of the total €117 million decrease in reserves from December 31st 2005 to March 31st 2006. This is basically the reserves are going down basically because we are let's say consolidating the restructuring reserves. For the other reserves, it's mostly costs which have been booked early in 2004(?) in certain contracts which we have disclosed at that time and it will be those which now go through the P&L. But if you take now the (low note?) about the P&L, you'll see that the overall impact of the reserves in the quarter will have been negative in operating profit.

Q - Richard Kramer, Arete Research

Was there any division in particular which was most impacted by that negative reserve reversal or reserves taken?

A - Jean-Pascal Beaufret

No, not particularly.

A - Mike Quigley

I think there was a second part of Richard's question, I'll just answer that if I can. Richard, you asked about was there any one single big purchase order in IP routing. The answer is no, we've now as I said, we had more than 25 wins in Q1, in fact it was 28, so we now have more than 130 customers across 50 countries, so our business now in IP routing is fairly widely spread. It's just a continual growth now with each of these new footprints we've got, we're starting to get some repeat orders, so it's a pretty solid business. The second question you asked was on - I guess you're asking the question about a possible cannibalization and impacts of customers delaying. We've been very clear, I think, in the discussions that we've had regarding the Lucent merger, that both companies will absolutely continue to support their customers. I can tell you from Alcatel's point of view, we will leave no customer in any difficulty in terms of continuation of platforms, we will be looking at, as I think the word we've used - a glide path - that will, at a time that's right for our customers, merge them onto what we think will be the right long-term platform for them. So there'll be real strengths there, but we're not going to force any customers into any difficulties. And hence we do not expect any customers waiting around or seeing what is going to be the ultimate platform.

Q - Richard Kramer, Arete Research

OK. Thank you.

Operator

Thank you. Your next question comes from Paul Sagawa at Bernstein and Company, please go ahead.

Q - Paul Sagawa, Sanford Bernstein & Co.

Thank you very much. A couple of quick things, first, Jean-Pascal, you mentioned the effect of currency on operating cost. I'm wondering if you could mention what impact changes in currency might have had on top line revenues. Then, tell me a little bit about the mix in your mobile business - several of your competitors have noted that there seems to be right now industry-wide a stronger mix of new-build networks versus expansion, and hinting that with the very strong subscriber growth that's going on eventually all of these new networks will come back to their original lenders to buy new equipment at better margins. Does that scenario kind of hold true in what you all are seeing in the overall market?

A - Jean-Pascal Beaufret

First point, Paul, there were in Q1, is what I said, significant impacts of the currency moves, (inaudible) currency moves over the quarter. This currency impact was 2.7% on the top line and was 4.1% on cost in SG&A and 2.1% on cost in R&D, because they are different locations. Just to tell you exactly what the consequences are, this has had an impact on SG&A which was much higher than on R&D.

A - Mike Quigley

And the second part of your question, Paul, I would confirm that yes, it probably is predominantly what we said in Q1, new builds.

Operator

And we will move onto our next question from Eiji Aono from Credit Suisse. Please go ahead.

Q - Eiji Aono from Credit Suisse

Hi, it's Eiji from Credit Suisse. Just on the mobile margins again, in Q1 last year, I think you had a bit of an impact from the BSNL contract, a negative impact then from BSNL, I think lower profitability. I'm assuming Q1 this year you had much less of an impact in terms of a lower margin, but the underlying margins were much weaker? So it does seem like the overall industry had a pretty significant amount of pricing pressure. Now just going forward, can you tell us what kind of impact you would expect? I'm not sure if you can split it out, but basically I'd like to see the impact of BSNL through the rest of the year as well as the general pricing pressure you're looking at. On BSNL, when will the new contract start having an impact, and will that be margin accretive or dilutive in mobile?

A - Jean-Pascal Beaufret

In Q1, the impact of increased investment in R&D and marketing is probably the main factor which reduced the margin compared to last year. As those expenses climbed more than the revenue, but we did this with good reasons, because we have some good reasons to put investment in NGN among other things, and in WiMax.

Q - Eiji Aono from Credit Suisse

OK, so the gross margin impact was not that…

A - Jean-Pascal Beaufret

In the (inaudible) really secondary - I'm not saying the pricing environment is secondary, it was also there, but again if you want to give a priority to the impact, the first impact is probably the largest.

A - Serge Tchuruk

I'd like to add something, but I don't want to be misunderstood. Mobile margins are sometimes in some businesses in Q1 2006 growing at the gross margin level versus Q1 2005. So don't disregard the fact that it varies from one business to the other, quite significantly. We have had significant improvement in gross margin in a good portion of our mobile business in Q1 2006 versus Q1 2005. Just to point it out.

Q - Eiji Aono from Credit Suisse

And was that the impact of a lesser impact from BSNL for example?

A - Jean-Pascal Beaufret

Yes, you have in the margin, Eiji, as you know, several extraordinary or specific items in the quarter which could be losses at a gross margin levels. It was in the past in 2004 and 2005, and then you have a pricing pressure, but as well you have cost improvement and I can tell you for a good portion of our mobile business in Q1 2006 we see a significant improvement at the gross margin level.

Q - Eiji Aono from Credit Suisse

And for the rest of the year, what do you expect then?

A - Jean-Pascal Beaufret

We expect gross margins, as I said to vary quarter to quarter. We've said that the last three quarters since the September quarter 2005, we've come in with gross margins of about 35%, which allows to say that we've reached a sustainable model. Of course, we are living in a pretty tough environment and we say that the quarter to quarter valuation of margins could also be significant. But we've reached a sustainable business model so far.

Q - Eiji Aono from Credit Suisse

OK. If I back some things out here, since satellite actually declined year on year and satellite's a lower gross margin business, and you're saying the gross margins improved in mobile, you're implying that fixed gross margins actually had a significant negative impact year on year in Q1. What would have caused that to happen then?

A - Jean-Pascal Beaufret

I wouldn’t make this calculation. I wouldn't make a mix of satellite on one hand, mobile on the other hand, because I'm speaking of a portion of the mobile business, and the full fixed communication business, in fixed we will show margins which are up Q1 2006 versus Q1 2005 and margins which are down. But we will not split it out into various different businesses.

A - Mike Quigley

So I think the message you're giving, Jean-Pascal, is if you look at mobile overall, Eiji, is the fact that there are some areas up, some down. And it's probably not too hard, you guys know, there is a lot of movement now on the NGN/IMS core. So there are customers who are accelerating that quite rapidly. The good news for us is that in that area in which Serge mentioned we've been investing, we now have live traffic on 60 networks worldwide, and we've carried over 15 billion live calls. So this is an area in which there was an investment, but we gained now a lot of traction, and we're gaining a lot of experience.

Eiji Aono from Credit Suisse

All right, thank you.

Operator

Thank you. Our next question comes from Francois Duheim(?) from CMCIC Securities. Please go ahead.

Q - Francois Duheim(?) from CMCIC Securities

Hello. I have three questions. The first one, you mentioned that you see some more growth in some countries for wire line than wireless. Could you just share with us which countries are those? My second question, for Jean-Pascal, would be about improved free cash flow in this year versus last year. If we take your last year numbers, could you share with us a part of the valuation of working capital that we may expect this year? Will that go up? And will you then still be able to improve free cash flow? And my last question would be about the GSM market. What would be the part of the catch-up effect in Q1 with the 6 million units and the part of the sustainable growth for you? Thank you.

A - Mike Quigley

Let me tackle the first question. I mentioned that we are seeing some markets in which our predictions of growth of 2006 over 2005 is higher in wire line than in wireless, and in fact that's what we believe will be the case in the North American market for 2006. Clearly for the developing world, the growth is higher in wireless than wire line. So it's those places who in fact are doing transformations, focusing on IP TV that we expect wire line will grow. Perhaps, Jean-Pascal, if you would - I'll come back to the third question that Francois had on DSL. I'm not quite sure I understood the question when you said catch up - I think what we're saying is it was a strong DSL quarter with 6 million lines shipped. And I think that just indicates our position where we dipped a little in 2005 in terms of market share, has now recovered in 2006 and we expect that to now continue throughout the year and gain market share 2006 over 2005.

A - Jean-Pascal Beaufret

On cash flows, Francois, the question has been tackled in our last call. We've shown in 2005 that we were able to raise the free cash flow level. We had a good generation of cash last year, after a still-significant restructuring payment of €440 million last year. We see this year several items for improvement. The first one is the current profitability and we are saying in the current operating margin, we do see a greater cash flow generation in 2006 compared to 2005. It means that the cash content of the operating profit will be better in 2006 than in 2005, which is what we've said on February 2nd and it's what we confirmed today with the results of Q1. You can see it from our cash flow statement in Q1 when you look at the line, operating cash flow. Because you've seen an improvement in it of €78 million. The second point, about the cash flow statement, will be the cash restructuring outlet which we see €150 million lower this year in 2006 than in 2005, and then we believe that we can cap the operating working capital requirements in 2006, despite the significant growth above market, the reason why we have factored some cash outlays for the full year operating working capital, but with improvement in terms of management of the assets. We see a slight improvement, a slight increase in CAPEX, just because we are facing strong demand by our customers in various areas where we have to test equipment for them and show them all the solutions that we have to develop in the three regions. Does it answer your question about cash flows?

Francois Duheim(?) from CMCIC Securities

What you said was clear, thank you very much.

Operator

Thank you. Our next question comes from Tim Daubenspeck from PacificCrest Securities. Please go ahead.

Q - Tim Daubenspeck, PacificCrest Securities

Thank you. First, a clarification. Serge, you made some comments about seven points of improvement from Lucent. Can you just clarify that comment? I didn't catch it specifically. The second part, in terms of investment, is there going to be an opportunity ahead of the Lucent deal to ramp down investments in certain areas where they might be strong? Is there a potential to see some type of impact on the op ex side in terms of ramping down certain investment ahead of the Lucent merger? Thank you.

A - Serge Tchuruk

On the seven points, yes, I'm going to answer, (there's another five questions?), I don't believe we can answer on this. Just translating what we both announced, in other words it should be cost savings of €1.4 billion for the combined company. If you are at the combined stage of the two companies, Lucent and Alcatel, you come up with a ratio of cost savings which are about seven points of (sales, 7% of sales?). So that's what we are trying to aim at. Not only are we trying to aim at it, we'll get it.

Q - Tim Daubenspeck, PacificCrest Securities

But in terms of - you know, Lucent made an announcement, as part of their results they mentioned that they were passing on certain unprofitable Indian business. Is there an opportunity that you might pass on certain businesses where they might be strong?

A - Serge Tchuruk

It's premature to answer these questions, and you know, in due time, we'll certainly look into this carefully.

Q - Tim Daubenspeck, PacificCrest Securities

OK, thank you.

Pascal Bantegnie

Operator, we'll take two more questions please.

Operator

Absolutely. We'll go to the line of (Peraz Ferrar?) from BMO. Please go ahead.

Q - (Peraz Ferrar?), BMO Financial Group

Good morning. Your guidance seems to indicate a slowing growth in the second half of the year. But the same sort of operating margins as you normally have, increasing in Q4. It there anything that could cause that to change? That's question one. And question two, in the Lucent merger agreement, you seem to have an out if Lucent's pension assets don't hit €28 billion. Can you define if that's pension assets before the unrecognized loss, or do you gross down the pension assets for the unrecognized loss?

A - Serge Tchuruk

On the second half being a bit lower in growth than the first half, it does remain that seasonally we always have a second half that is higher than the first half. It doesn't change.

Q - (Peraz Ferrar?), BMO Financial Group

Then so you expect operating margins to expand and…

A - Serge Tchuruk

Then obviously - the more business you generate, the high repentance(?) to move the operating margin, so generally the operating margins are better in the second half.

A - Jean-Pascal Beaufret

About our merger agreement, I guess the wording of it is absolutely self explanatory. Speaking on the (seven new assets?), which is one of the key metrics which is disclosed by our partners, by Lucent, and we believe that this doesn't open any questions about recognized or unrecognized losses or gains.

Q - (Peraz Ferrar?), BMO Financial Group

When you acquire the company, will you have to gross down the pension assets for the year, do a fair value assessment of those assets and gross them down for the unrecognized losses, Jean-Pascal?

A - Jean-Pascal Beaufret

I believe that - I won't answer this question. What has been published is absolutely self explanatory.

(Peraz Ferrar?), BMO Financial Group

Thank you.

Operator

Thank you, and our final question will come from Per Lindtorp from ABN Amro. Please go ahead.

Q - Per Lindtorp, ABN Amro

I have a question on SG&A and a little bit on both SG&A and the impact from provisions in operating profit in general. If you look at the average of reverse provisions, and also preparations, reversals are around 50% which is way below the average. The question basically is this kind of a new average? Or do you see that provisions had a significantly negative impact on operating profit in the quarter? Then if you back out the capital gain from SG&A we end up with around €530 million. That was a very high level and you touched upon it a little bit, where that might go during the year. Is there any other extraordinary (inaudible) in the SG&A line for the quarter? Thank you.

A - Jean-Pascal Beaufret

I'm more than happy to answer the second portion of your question, Per, for the first part of your question I'd like to refer you to note 15, which is subject to discussion every quarter, which gives all details about the appropriation of provisions, their net impact on P&L and so forth. So the first part of your question, the SG&A as posted has been 5.4 in the quarter, where we were at 498 in Q1 2005. But you're right saying this has been impacted positively by €28 million capital gains, which makes the SG&A for the full quarter Q1 2006 as €532 million, which is a 6.8% increase. But out of that, you have to make the differentiation between Euro-Dollar impact, and what if a real volume impact. What I said previously is that the real volume impact is 2.7%, the Euro-Dollar impact has been affected by the fact that for the most part, a higher proportion of our SG&A is reported in Dollar-related currency. Thank you.

Per Lindtorp, ABN Amro

Thank you.

Operator

Thank you. With that, I'll turn the conference back over to you. Ladies and gentlemen, this conference will be available for replay after 6.15 France time, until May 11th at midnight. Operator instructions. You may now disconnect.

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