Should You Buy Alcatel-Lucent After Huge Declines?

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By Nawazish Mirza

Alcatel-Lucent (ALU) is a small-cap telecom company that offers a promising upside potential owing to its management efforts to position well in a competitive industry. Today (Tuesday), the stock lost 18% of its value after it warned investors that it will miss its adjusted 2012 operating margin. At present, the stock is deeply undervalued with a P/E ratio of 1.63 that we expect to increase to 6.9 in the wake of its local and global expansion. This will positively impact cash flows for the firm. Management efforts yielded dividends in the 2011 fiscal year, propelling a rebound in profitability with a return on investment of 17.7% after reporting consecutive losses since 2006.

Going forward, we expect Alcatel-Lucent to capitalize on its ability to provide high speed broadband internet in local and global markets together with economies of scale to improve on margins, cash flows and stock price. We acknowledge increasing competition from other players like Verizon (NYSE:VZ), but we expect future financial benefits from Alcatel-Lucent's recent penetration into rural areas. This ought to help the firm stabilize its earning capacity.

Key Thesis Points

1. ALU is a French technology firm that provides networking and communication product services to its consumers in United States and around the globe with a focus on innovation. Its product portfolio is well-positioned, with 62% of revenue generated by networks (a result from an increase in the IP segment) and 28% generated by software, services, and solutions. The geographic mix is not surprising at all: North America contributes 38% of total revenue. The revenues in North America were driven by rapid growth in smartphones and video demands that contributed significantly towards the IP segment. European subsidiaries, despite the prevailing debt crisis, were able to contribute 30% in total sales.

2. Fiscal year 2011 was a changeover year for Alcatel-Lucent when it reported an operating profit of $230 million compared to a loss of $384 million in 2010. As a result, the company saw a net margin of 5.5% in 2011--the highest since its merger in 2006. This is primarily because of profits emanating from relatively mature markets of North America and Europe. The key to future growth for technology stocks lies in providing better service quality and tapping international markets with limited or no access.

To cope with the demand in Europe, Alcatel-Lucent is planning capacity expansion, and we expect augmented revenues once the sovereign debt clouds in European skies ease out. The Asia-Pacific region is also offering strong opportunities, where the company has signed agreements with three of the leading Chinese operators to provide internet services in 31 areas. We expect revenues to get a significant boost from fixed and wireless broadband services in the Asia-Pacific region, increasing the profitability of the firm. Furthermore, investors' confidence will get a push from the fact that Alcatel-Lucent's reputation is being recognized by many international players (Bharti Airtel, Telefonica (NYSE:TEF) to name a couple) who are opting for the Alcatel-Lucent's services and products. We expect that in the future, such opportunities are likely to strengthen the fundamentals of the firm resulting in an increase in share price.

3. Alcatel-Lucent operates in an industry where innovation is the key to success. The company is well positioned to capitalize on this innovation strategy. We recommend Alcatel-Lucent over its peers like AT&T (NYSE:T) and Sprint (NYSE:S) for its growth potential, general strategy, and technological flexibility. Moreover, AT&T is trailing at a very high P/E ratio of 51, offering limited upside given the fact that the company is already under criticism for its sub-par customer service. A similar situation is faced by Sprint, which reported a loss per share of $1.11. Furthermore, its reputation suffered a setback when the company was ordered to settle a $19 million lawsuit for picture messaging charge errors.

Bottom Line

The primary factor favoring Alcatel-Lucent is its deep undervaluation. This provides a limit to any further regression. Historically, the company was not performed well. However, with augmenting margins and cash flows in 2011 coupled with future ventures and the company's strategy of cost cuts, we expect fundamentals to lead a rebound in stock price. This is a turnaround story and a risky investment though. You should allocate only a very small percentage of your portfolio to these types of investments. These stocks are more likely to disappoint but when one of these stocks manages to turn things around, the gains from this investment will more than cover your losses in your failed bets.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.