Is Now The Time To Dump This Telecom Giant?

| About: Nokia Corporation (NOK)

Austerity trends have arrived for companies in the Code Division Multiple Access (OTCPK:CDMA) business. Weak demand for network equipment and rising competition plagues the sector. The effects of declining demand in North America for network gear that runs on CDMA have been terrible. The entire sector is weak, but some companies are more vulnerable than others.

Recently, Alcatel-Lucent (ALU) reported second quarter results that showed a $312 billion loss. Its sales fell 7.1% from the period a year ago to about $4 billion. Alcatel-Lucent's revenue from North America, which accounted for 39% of sales, fell 8.3% to $1.7 billion during the quarter. Alcatel-Lucent posted operating margins of 4% at the end of 2011, while its rival, Sweden-based Ericsson (NASDAQ:ERIC), managed a margin for underlying earnings of 11.6%. China's Huawei reported an operating margin of 15.8% in 2010, the last year for which figures are available.

I believe that Alcatel-Lucent is significantly undervalued at its current price of around $1 per share, but I don't believe it is certain to grow in the next few years. While its rivals such as Cisco (NASDAQ:CSCO), Nokia (NYSE:NOK), Siemens (SI), and Ericsson are coping in a deteriorating macroeconomic environment, Alcatel-Lucent is going through a painful program to accelerate its transformation and reduce costs in order to keep ahead of market pressures.

Alcatel-Lucent may not prosper for several reasons. First, the CDMA business is disappearing. Verizon (NYSE:VZ), the market leader in the U.S., is phasing it out. Second, Alcatel-Lucent is faced with increasing pressure from its telecom vendor rivals and the harsh global economy. Third, Alcatel-Lucent is struggling to make the transition from older 3G mobile technologies to new 4G networks. And finally, its massive investments in older 2G and 3G technologies have dwindled as carriers look to LTE.

Alcatel-Lucent wants to slash 5,000 jobs by the end of 2013 to survive the hard business environment. The cuts will affect all parts of the company except research and development. While the job losses aren't as severe as the 17,000 layoffs Nokia Siemens announced in December 2011, they represent 7% of Alcatel-Lucent's total employee base.

Alcatel-Lucent intends to tap one source of income to build some very good and profitable business. It hopes to create a separate business division to manage its 44,000 patents. It will also exploit Bell Labs, the wellspring of many of the world's most important technological inventions. However, Bell Labs has seen its once large applied research budget cut, and the company is now a shadow of its former self.

Alcatel-Lucent will continue to invest in core areas of operations and geographies aggressively, as well as break new ground. Recently, it made some penetration into rural areas, and analysts believe this will help the firm stabilize its earnings capacity.

Furthermore, Alcatel-Lucent will continue to partner with international players such as Telefonica (NYSE:TEF) and Bharti Airtel, which recognized its expertise by opting for its products and services. Alcatel-Lucent watchers feel that such opportunities should strengthen the company's fundamentals, and result in an increase in share price.

Unfortunately, Alcatel-Lucent may find it difficult to get out of its tough situation. According to a recent ABI Research study, Alcatel-Lucent came in fourth in an LTE market that many believe can only support two or three primary equipment makers. Nokia Siemens is the LTE vendor market leader in terms of intellectual property and contracts. Ericsson and Huawei are ranked second and third, respectively.

While Alcatel-Lucent landed major parts of Verizon's, AT&T's (NYSE:T), and Sprint Nextel's (NYSE:S) LTE contracts, it ceded market share to its three major rivals in international markets, worsening its situation.

Alcatel-Lucent's case is further complicated by a volatile economic outlook that may lead some big telecoms to cut network investments this year. Though Alcatel-Lucent continues to show strength in market segments such as IP, Next Generation Optics, and Broadband access, it is faced with the problem of weak demand for the products.

TEXT-S&P, a team of analysts, expects Alcatel-Lucent to report higher cash flow losses in 2012 and 2013 than it anticipated due to its more cautious spending and fierce ongoing competition. The analysts then revised their outlook on Alcatel-Lucent to negative from stable, but affirming the "B" ratings. "The negative outlook reflects the possibility of a downgrade over the next six to 12 months if the group's currently strong cash balances and adequate liquidity profile were impaired by continued significantly negative free cash flow or a lack of refinancing," said TEXT-S&P analysts.

Alcatel-Lucent management's stated ambition is to return the company to health by cutting jobs and costs. It also plans capacity expansion, expecting to augment the company's income once sovereign debt clouds in the European skies shrink.

Alcatel-Lucent is deeply undervalued from a valuation standpoint. Its price-to-sales ratio of 0.13 is competitive when compared to 1.98 for Cisco, 0.87 for Ericsson, and 0.94 for the industry average. Its price-to-earnings ratio is 1.49, compared to 11.60 for Cisco, 14.07 for Ericsson, and 13.39 for the industry.

But I am not confident about Alcatel-Lucent's prospects for growing its cash flow. As Alcatel-Lucent continues its struggle to accelerate transformation and reduce costs by as much as $1.5 billion by the end of 2013, one expects a rebound in the stock price. But the company has not performed well for several years. Mark Hawtin, head of investments at GAM U.K. Ltd., does not see a way out for the company. Considering all of these negative factors and very few near-term positive catalysts, I think investors should strongly consider selling this stock right away.

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.