European Telecom: Bernstein Bullish on Equipment, Bearish on Handsets

Includes: ERIC, NOK
by: Eric Savitz

Bernstein Research analyst Pierre Ferragu today launched coverage of the European telecommunications equipment sector. He is bullish on the networking sector, but negative on devices. Ergo, he launched Ericsson (NASDAQ:ERIC) with an Outperform rating, Alcatel-Lucent (ALU) at Market Perform and starts Nokia (NYSE:NOK) at Underperform.

Ferragu sees network equipment sales growing 7% a year through 2012, up from 4% on average from 2002 to 2007 “as a result of the explosion of data traffic,” which he sees grow 75% a year, and continued growth in voice traffic of about 20% a year. “We also expect profitability to improve as demand picks up and the competitive landscape stabilizes,” he writes. Ferragu says there will be four drivers for equipment sector:

  • Smartphone penetration will drive “unprecedented data traffic growth.”
  • Data card penetration is “where the actual revolution lies.” He says operators in Europe are considering subsidizing ultraportable laptops; other consider offering 3G as a substitute for DSL to people with no fixed lines.
  • Subscription growth expected to grow 12% a year through 2012.
  • Voice usage growth: Minutes of usage growth slowing in developed markets, but still accelerating in the developing world. Expects minutes to grow 7% a year through 2012.

On the other hand, he is negative on devices. Ferragu says he believes in the rise of mobile broadband, and he sees 36% annual growth in smartphones. But he sees the value of the device market flattening out, with -0.6% revenue growth on average through 2012. “Based on proprietary research, we believe consumers are not likely to spend more as they trade up toward smartphones, and there that average selling prices will continue to slide,” he writes. Ferragu sees volume growth in mobile phones slowing to 7.4% though 2012, down from 21% per annum in the 2002-2007 period. “We also expect margins to contract as competition picks up.” Here’s his list of four reasons for being bearish on devices:

  • Volume growth is slowing down.
  • ASP decline will more than offset volume growth in medium term.
  • Margins at historic highs and likely to come under pressure.
  • Threats weighing on the industry include sensitivity to economic weakness in Europe and U.S.; fragile demand in developing markets given surge in food prices and risk of downturn; threats from new entrants and alternative terminals like ultraportable laptops “eating up subsidy budgets as mobile broadband develops.”

Ericsson, he says, “will benefit from the positive backdrop for networks and continue profitably grow its service business.” He concedes that Sony-Ericsson will “face challenges,” but contends “this should weight only marginally on the stock’s performance.”

Alcatel-Lucent, he says, with only 13% of its business from GSM/WCDMA hardware, “is not well positioned to capture to mobile broadband opportunity.” He says a sum-of-the-parts analysis “reveals higher valuation potential,” but he sees no near-term catalyst to capture it.

Nokia, he cautions, faces “a demand slowdown, margin pressure and possibly market share losses.” He notes that the stock is already down 40% year to date, but contends that EPS is likely to be down as much as 9% in the next two years, worse than the Street consensus for 7% growth. He says the stock is likely to fall to a multiple of 1x sales, from a recent 1.1x “to reflect the company’s poor growth prospects.”