The Telecommunications Equipment Manufacturing TEM industry is an interesting industry because many of its core products have been commoditized, in other words the lack of differentiation between the various manufacturers' brands leads consumers to buy the least expensive product offered. Fifteen years ago, the industry had undergone a revolution with Cisco (NASDAQ:CSCO), Alcatel, Lucent, Ericsson (NASDAQ:ERIC), and Nortel Networks seeming poised to dominate the market. However, about eight years ago the industry was further shaken up by the entrance of Huawei and ZTE, two Chinese companies with access to lots of capital and cheap labor, both crucial in a commoditized market where every cent counts. Gradually the Chinese firms gained market share, while Nortel Networks declared bankruptcy and the other Western firms struggled. Though many firms have still not returned to profitability, they have been slashing operating costs, consolidating their businesses, and focusing on niche markets. Alcatel-Lucent , the product of a 2006 merger, had shown much initial promise, but failed to return to profitability after the 2008 financial crisis. Though some investors fear that Alcatel-Lucent may go the way of Nortel Networks, recently Wall Street has expressed confidence in the French telecommunications company and the stock has risen more than 90% since its October 2012 nadir. Though Alcatel-Lucent remains in a tough financial position, an analysis of the overall TEM industry, the fundamental strengths of Alcatel-Lucent, and I Know First's stock predicting algorithm indicate that the company has the potential to return to profitability and become a market leader once again.
The Telecommunications Equipment Manufacturing Industry
Western firms had dominated the TEM industry fifteen years ago when the industry was still relatively immature, profits were strong, and competition weak. Once the industry began to develop and commoditize, however, existing TEM companies were forced to adapt to survive (Chart 1). Many Western firms failed to recognize the urgency of their situations and were too slow to adapt.
The leadership drastically underestimated their ascending Chinese competitors, and like Michel Rahier of Alcatel-Lucent, they wrongly concluded that Chinese companies did not have the technology and sophistication to match that of Western companies. This miscalculation allowed the Chinese company, Huawei, to become the largest telecommunications equipment manufacturer in 2012. Though Western companies may have been slow to adapt to the slim profit margins of the industry, they have made efforts to cut operating costs and have been maintaining decent market shares.
Slim profit margins and negative profitability are commonplace in the TEM industry, Ericsson, for example, has struggled with profitability for the last two decades, but has rebounded because of its sustained market share and strong line of products. Even though its profits declined by 86 percent in the first quarter of this year, Ericsson is predicted to succeed in the future. ZTE, the second largest Chinese TEM company, has maintained negative profits for the past few years, but it too is braced for a strong recovery. Alcatel-Lucent has still failed to return to profitability, but it has been making many structural changes including hiring a new CEO and is preparing to embrace new telecommunications niches. In anticipation of strong comebacks, the stocks of Ericsson, ZTE, and Alcatel-Lucent have all grown robustly in the past year.
Alcatel-Lucent's Fundamental Strengths
There is no doubt that Alcatel-Lucent has been suffering financially. It has spent an average of 700 million euros a year restructuring its debt from the merger between Alcatel and Lucent (this year it is expected to spend 500 million euros); and its first-quarter operating loss this year was 353 million euros, its fourth consecutive quarter of negative profit. However, the company's sales have been growing and it has been maintaining its market share (Charts 2&3).
It is currently the third largest telecommunication equipment manufacturer behind Huawei and Ericsson, and according to 60 Minutes, it is one of the only three companies capable of building 4G networks. Alcatel-Lucent has also been cutting its fixed and variable costs in an attempt to return to profitability (Charts 4&5).
Even though Alcatel-Lucent has been struggling financially, it has maintained strong R&D investments through its world-renowned research division, Bell Labs and its R&D spending has helped it accumulate a 30,700 patent portfolio. Last year MIT's Technology Review ranked Alcatel-Lucent as one of the Top 50 most innovative companies and Thomson Reuters listed it as one of the world's Top 100 most innovative companies. In accordance with its reputation for innovation, on July 17, 2013 Alcatel-Lucent announced that it broke the single-fiber optical transmission record for transoceanic distances.
Even though Alcatel-Lucent has both a large market share in the telecommunications equipment manufacturing industry and a strong R&D division that provides it with new, groundbreaking products, the stock market values it at less than $4.5 billion dollars. This is less than Nortel Networks received after selling its patent portfolio when it went bankrupt. Alcatel-Lucent's direct competitors, Ericsson and ZTE, are valued at 40.49B and 47.09B respectively. (Huawei is privately owned). Even though both Ericsson and ZTE have experienced a tough decade, Alcatel-Lucent's valuation has fallen much further.
How I Know First's Algorithm Predicts the Stock Market
Before investing in a stock, it is best to study at least two independent methods of analysis, because if they both point in the same direction, the significance of their prediction is much higher. Therefore, instead of relying on fundamental analysis alone, it's worthwhile to consider an alternate method, such as a self-learning algorithm, to predict the direction of Alcatel-Lucent.
I Know First co-founder, Dr. Lipa Roitman explains that though fundamental analysis and technical analysis are important to consider, these can often be arbitrary indicators because there are many conflicting ways to value companies and conflicting patterns in past performances. Additionally, investors of all schools of thought are prone to cave to human biases. Roitman explains that chaos, a non-linear evolving system, plays a large role in moving the stock market. Though chaos is not random, it is often counterintuitive and thus is often misinterpreted. Quasi-deterministic chaos is responsible for creating waves in the market that are predictable and analyzable with processes developed in complex mathematics and quantum physics. Even though the Heisenberg Uncertainty Principle says that it is impossible to precisely record both the momentum and position of an electron at the same time, the properties of an agglomeration of multiple electrons, or waves, is well understood. Similarly, it is difficult to analyze individual transactions in the stock market (quanta), but it much easier to interpret long-term trends (waves). I Know First's market prediction algorithm uses artificial intelligence, machine learning, artificial neural networks, and genetic algorithms to track waves between the recent trajectory of a specific stock and the historical movement of an aggregate of other assets; and as the algorithm is self-learning, it constantly updates itself and improves its forecasts. The algorithm predicts the direction that stocks will move as well as the magnitude that they will move in that direction. The magnitude of the movement is measured by the "signal strength" - the higher the signal, the more upward potential the stock has.
I Know First's Algorithmic Prediction for Alcatel-Lucent
On December 20th 2012, the algorithm gave Alcatel-Lucent a signal of 239 for its 3-month prediction, on December 23rd, 2012 a signal of 556, on December 28th, 2012 a signal of 184, on January 14th, 2013 a signal of 187, on February 28th, 2013 a signal of 1643, and on April 2nd, 2013 a signal of 1893 (Chart 6). The gradual increase of Alcatel-Lucent's signal indicates that the algorithm was becoming more and more confident that it was poised for a large increase. (The decrease in the signals in late December and January is a sign that the algorithm was less confident in the direction of the stock -interestingly the stock experienced a slight correction shortly afterward). The algorithm is best at predicting long-term trends. Therefore, even if there may be some short-term corrections, such a sustained upward prediction presages a strong, sustained increase in stock price. Chart 7 shows the actual movement of Alcatel-Lucent in dark blue, and the algorithm's prediction of the stock's future movement in lighter colors. (The higher the prediction lines are above the line, the stronger the algorithm believes the stock will increase and vice versa for prediction lines below the actual stock price).
The recent algorithmic predictions for Alcatel-Lucent (Chart 6) are interesting because the signals' strengths though still positive, have been decreasing. On June 14th the signal was 895 and on July 17th it was 495. Though the algorithm is still confident that Alcatel-Lucent will grow in the long term, the decreasing trend of signals signifies that the algorithm believes that there may be a slight correction in the near term. Perhaps it is better to wait a while to buy Alcatel-Lucent stock when it is even more of a bargain. This downward trend is similar to the December/January downward trend that presaged the slight correction.
Of course not everyone believes that Alcatel-Lucent is capable of regaining its former glory; Elisa Lemmola of Seeking Alpha argues that the company has bad management, a poor business plan, and strong competitors with whom it can't compete. She also suggests that the only reason Alcatel-Lucent's stock has increased recently is because the new CEO, Michel Combes, has convinced Wall Street that he will succeed in making Alcatel-Lucent profitable by selling off non-integral divisions - the same strategy employed by his unsuccessful predecessor.
I believe that Alcatel-Lucent is poised to grow significantly in the long term because of its strong, underappreciated fundamental strengths and because of the analysis of I Know First's algorithm. It helps, moreover, that Alcatel-Lucent is part of a resilient industry that often deals with negative profit flows; and once the company has finished paying off its restructuring debt from the merger, it should be in a strong position to retake the offensive. Because the algorithm is suggesting that there may be a slight correction soon, I advise investors to wait some time before jumping in, but Alcatel-Lucent is definitely a long-term buy.
Business relationship disclosure: I Know First Research is the analytic branch of I Know First, a financial startup company that specializes in quantitatively predicting the stock market. This article was written by Ethan Fried (Harvard College '16) one of our interns. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.
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.