Excerpts from a June 27 report from Merrill
Buy case revisited
Company Description
Alcatel-Lucent manufactures telco equipment, and
offers telco services. The Company's equipment
and services enable its customers to send or
receive virtually any type of voice or data
transmission. Alcatel-Lucent designs and builds
public and private networks, comms systems and
software, & data networking systems. Source:
Bloomberg.
Investment Thesis
ALU's historical average op margin is 5%. The peer
group is 10-20%. For much of the last 15 years the
valuation of ALU and its predecessor Alcatel has
implied margins will move to the lower end of the
peer group range. Not any more. This is what
makes the stock compelling as ALU's portfolio now
has significant exposure to segments that will see
more, not less, customer focus. The old inefficient
conglomerate structure is being dismantled by the
first "outside" management in 15 years.
Back to March levels
Consensus estimates have been moving up, but the stock is back to March share
price levels like much of tech hardware, we think partly due to some optics market
competitor weakness (19% of ALU Q1 revenue). Telecom spending is rebounding
this year as operator capex reverts to mean and we consider this a late-cycle
defensive market to be exposed to. ALU, unlike Ericsson, is exposed to multiple
sub-segments, has disruptive technology, and has a cost-cutting story.
New IP products
Tomorrow ALU is announcing new IP router products. The webcast is worth
watching to see IP division head, Basil Alwan, who is rarely seen by investors in
Europe (10am ET, 3pm UK, 4pm CET). While we’re not expecting a consensusmoving
event, the rise of this business from almost nothing to 20% share in 5
years to become the number 2 after Cisco, reminds us there are valuable assets
in ALU. Look for ALU pushing its routing technology out into segments such as
mobile , and also closely linked into optical transport solutions.
0.56x EV/Sales, we target 7-8% operating margins
In this detailed report we look at the latest router and optics market data, remind
why LightRadio is so disruptive, and run through the product and cost-cutting
story at ALU. Our price objective would put the stock on 0.75x 2011 EV/sales. On
a 2-3 year view we think it likely the market will start to discount 10% margins for
ALU (that would be 78% share price upside to €6.6/$9.4) as the company
executes its plan to cut opex from 35% to 28% or so of sales, and as higher
margin growing businesses rise as a percentage of mix.
Router snapshot – 12% of Q1 revenue
Alcatel acquired Slicon Valley based router company Timetra in 2003 for $150m
and this business forms the bulk of what ALU calls its IP Division.
Timetra CEO Basil Alwan is still with the company and is very well respected in the
industry. He ascribes success to a vertically integrated focus (ALU is now on its
fourth generation home-designed router silicon) and a design, from the start, for
telco’s rather than enterprise. Enterprise equipment buyers have not historically
demanded the reliability and fault tolerance of telco companies where telco’s
revenue is tied to service level agreements with its own enterprise customers.
The bigger router segment by revenue is Edge Routing (the other being core
routing at under half the market size). Edge routers have the most “intellgence” and
are used not only to route traffic but also inspect traffic to allow complex billing,
quality of service management, and allow revenue generating new applications to
be delivered to customer by operators. This is where ALU’s product sells today.
ALU reported 27% dollar growth in its IP division in Q1. This includes legacy ATM
switch business which is not included in the data we present below.
[chart not included here]
On June 28th ALU is scheduled to release a product update which it describes as
a “groundbreaking breakthrough”. ALU has used this language before without it
being a share price moving event. Even really disruptive ideas, such as lightradio
in ALU’s wireless business, didn’t materially move the share price on
announcement. However after recent share price weakness it refocuses attention
on ALU and will likely hardly be a negative event for the share price.
What might they announce? A core router product, more integration with the
optical division business to provide OTN (optical transport network) offload, a hot
topic in the industry today and discussed in our Deep Dive report), more working
with the wireless division to support the market leading basestation-router
businesses, or perhaps a more data-center/enterprise related product.
Optical networking snapshot - 19% of ALU Q1
Comprises legacy voice telephony trunk technology (SDH/Sonet) which still
makes up the majority of installed base, and IP based WDM (wave division
multiplex). It does not include broadband access technologies such as PON.
According to Ovum the optical networking
market fell -10% in 2009 and -2% in 2010
to $14.4bn. But growth rates turned
positive in Q3 10 and were +7% in Q1,
with ALU reporting +15% for its optical
division.
Regional shifts explain share changes.
North America troughed as China peaked
in 2009, and EMEA started to pick up mid
2010. This explains Huawei’s share loss,
and Ciena and Fujitsu’s share gain.
Negative pre-announcements from optical
component suppliers such as Finisar are
partly explained by such company’s
dependence on Chinese vendors. Huawei
(and ZTE and Fiberhome’s) unit market
share is higher than revenue share which
means the fall in China driven spend is
amplified for its component suppliers.
This does not impact ALU.
Ex APAC, shares have been relatively
stable with ALU a clear, though slightly
declining, market leader.
ALU management admits they were late
in 40G WDM but claim to have recovered
strongly with nascent 100G technology
that will be powering networks in a few
years time. Ciena came first with
coherent 100G but ALU was the first to do
coherent on a single WDM wavelength.
ALU is also strong in submarine (the other
main competitor is Tyco Electronics)
which declined in 2010 but is now
recovering.
North America optical networking, 30% of
global total, was up 7% in 2010, which
EMEA and APAC fell -10% and -2%
respectively. The market share pattern in
North America is different from the rest
of the world, with Ciena (which acquired
Nortel’s optical assets) and Fujitsu
leading, explaining US investor’s focus on
this stock as a comp for ALU.
LightRadio – cloud mobile
Although our estimates do not assume
material profitability for wireless,
LightRadio could prove us wrong.
ALU put the rest of the industry on the back foot with the introduction of its
LightRadio cube in February this year. NSN announced a similar concept, Liquid
Radio, as did Ericsson with a photograph of its Korean “basestation hotel” at its
recent management briefing. But ALU appears to have first mover advantage and
operators working with ALU to develop and test the technology include China
Mobile and Telefonica.
The concept could be very disruptive to the industry, taking all the baseband
processor heart out of the cell-site and doing it in a datacenter. Like cloud
computing, processing power is centralised resulting in substantial cost
efficiencies. The cell site becomes a relatively cheap active antenna (combining
the antenna and some radio frequency electronics) connected to the data center
via a high capacity fiber link.
All things being equal, cloud-mobile architectures like LightRadio would reduce
the cost of deploying a mobile network. However we suspect this would simply
lead to the deployment of more capacity. Net net, another reason why carrier
capex/sales will not likely balloon.
Buy case revisited
Back in March we raised our price-objective to EUR5. The stock is now back to
March levels, another particularly good opportunity we believe. In our view, the
investment case rests on:
?? The hardware story – legacy products fading, good for margins and growth
?? The software story – application enablement
?? The services story – more clarification needed on the path to profitability
?? The cost-cutting story – just beginning to see benefits
The hardware story – Networks division
ALU’s reported revenue mix (chart 1) does not help investors assess growth,
mixing as it does new and legacy businesses. But since Q310 ALU has split out
its Network division revenues (which in Chart 1 are IP, Optics, Wireless, and
Wireline) by Nextgen and Legacy products (chart 2).
IN the 12 months to Q1 2011, NextGen grew 24%, legacy -1% in dollar terms.
Nextgen revenues are defined as IP routers (including backhaul and evolved
packet core wireless applications), DWDM optical networking, WCDMA/3G
wireless, LTE/4G wireless, IP DSLAM (multi-standard access gateways), fibre
access, and IMS core softswitches. CDMA is not included, and this was a
mistake as the 3.5G version of CDMA, EV-DO, grew strongly in Q1 2011 thanks
to Verizon’s spending, and this led legacy to outgrow next gen in that quarter.
The seeds for the growth in Nextgen were laid in early 2009. The then new CEO
and CFO team reorganised and refocused R&D around their High Leveraged
Network (HLN) strategy, aimed at helping telcos deal with growing data traffic and
the need to migrate separate (and now inefficient) residential, business, and
mobile networks into one IP (internet protocol) network. Part of this involves the
concept of the network as the application platform – creating the “software story”
of Application Enablement that we discuss in the next section.
R&D shifted to next gen products including end-to-end LTE (including backhaul
and evolved packet core products that do not actually sit in ALU’s “wireless”
segment), IP platforms, 100G Ethernet, coherent optical transport (only ALU and
Ciena have commercial product here), packet optical and optical transport
networks, converged network management (meaning central management of IP
and optics), and the software and application services to sit on top of this.
Nextgen provides not only growth but also higher margins. ALU has had some
recent success being first-to-market with new technologies, leveraging the
competitive window of opportunity and creating a barrier to avoid pure box-selling
competition. New management also describes how old ALU created too many
customer-specific solutions which made the cost unbearable. The company also
tended to design for maximum specification and then attempt to cost cut rather than
build a high volume stripped down low cost product first, and then add functionality
when needed. There is still a significant higher-cost legacy business in place, which
partly explains ALU’s still low profitability compared to its peer group.
Wireline legacy waning
According to Ovum, ALU ranks 2nd in broadband access, optical networking, and
service provider routing.
The charts below show how ALU’s business has become far less reliant on
legacy products (such as voice optical transport (SDH/Sonet)), voice switching,
and DSL access. Here “wireline” is what ALU would describe as the sum of its IP,
Optical, and Wireline divisions.
ALU’s secret has been a common strategy across transport, switching, and
routing products (known in the trade as layer 1 to layer 3) and the use of the
same platforms for residential fixed, business fixed, and mobile networks. None of
its competitors have the same platform approach. ALU also differentiated by
offering communications products to industries such as energy, transportation,
and public-safety which also require telecom-like reliability.
[EDIT: Charts are omitted from this excerpt, as are other sections.] |
