ALU: Bernstein, Raymond James Take Sides on Wireless Peril, Promise
By Tiernan Ray
Bernstein Research’s Pierre Ferragu, who rates shares of Alcatel-Lucent ( ALU) Market Perform, with a $1.85 price target, today offers up the third installment of his multi-part overview of the telecom equipment companies, in which he concludes that Alcatel has a mixed outlook in wireless infrastructure: a “relatively stable footprint,” but also a “subscale” business that will continue to lose money for the foreseeable future.
Specifically, Alcatel has 10% share of the market for base stations and wireless equipment, compared to 42% for Ericson ( ERIC), 20% for Nokia-Siemens Networks (the joint venture of Nokia ( NOK) and Siemens AG ( SI)), and 18% or so for China’s Huawei.
That trailing position is made more difficult, writes Ferragu, as traditional “CDMA” cellular networking becomes passe, leading to reduced spending on the equipment by carriers. (Alcatel gets 34% of its wireless revenue from North America, he notes, boosted by capital spending from Verizon Communications ( VZ), among others.)
Ferragu expects the company to lose market share as carrier spendingshifts from GSM and CDMA to spending on more advanced 4G networks.
The drop-off in CDMA investment has pushed the company from being break-even in its wireless business last year and the year before to what Ferragu projects will be an 8% loss this year.
The best Alcatel can hope for, thinks Ferragu, is that the wireless margin will remain negative but not quite as bad, perhaps 7% next year and 6% the year after. At that rate, Alcatel can continue to remain profitable on an operating basis at a “group” level.
But the company’s margin expansion prospects are nevertheless limited despite other areas of strength:
The company’s scale disadvantage in GSM/WCDMA and high exposure to the shrinking CDMA market makes Wireless structurally loss-making and declining. The company still has a number of valuable assets – IP, Submarine Optics, and Services that compensate for these structural weaknesses, but in a normalized state, we believe the company cannot aspire to operating margins and growth at above 4%.
Ferragu is further concerned that gross profit may come under pressure in IP routing products sales, where competitors Cisco Systems ( CSCO) and Juniper Networks ( JNPR) have seen margin erosion:
We are nevertheless worried that the company could be suffering from significant margin headwind: In IP routing competitors have seen margins fall in the last year, in the context of increasing price competition, and the decline of US CDMA revenues has harmed the gross margins of competitors in wireless equipment. These factors did not have much impact on Alcatel-Lucent’s gross margin last year and could simply resurface now.
If pressure materializes there, along with a decline in wireless sales, Alcatel could face a cash crunch, Ferragu opines:
The latter interpretation implies potentially disastrous developments for the company. Our analysis suggests that if gross margins stay at 1Q12 levels, the company could be in a very challenging position when its $765m convertible debenture is due for refinancing in mid-2013. We estimate the company could be left with ~€2bn of cash by then, making this refinancing difficult (remember Nortel filed for bankruptcy with $2.4bn in cash) and the subsequent refinancing probably impossible.
Alcatel shares this afternoon are up a penny, or 0.6%, at $1.59.
Update: A quite different perspective was offered today by Raymond James’s Simon Leopold, who reiterated an Outperform rating on the shares and a $4 target price.
Leopold concedes margins on wireless are an issue, however he thinks the business can still be a good one for Alcatel, given it’s possible the company may gain share:
Alcatel-Lucent’s stock continues to confound and frustrate us because it remains so inexpensive with an EV to CY12 sales ratio of 0.1x. Improving wireless margins in 2012 may represent a challenge considering the shifts in mix and volume, but over the longer term, this looks like a growth driver that could lead to market share gains. With positive net cash and improving cost structure, we consider the shares attractive, yet the overhang from the macro economy continues to worry investors [...] LTE presents an opportunity for share gains and growth in 2012 and beyond, yet early sales likely drag on the wireless operating margin. However, aggressive LTE spending by U.S. carriers, China Mobile and wins in the higher margin evolved packet core along with overall cost cutting could offset weakness. Wireless is an attractive vertical with equipment spending growing 10% in 2012 to $50.5 billion according to Infonetics. In the U.S., wireless carrier capital spending will grow 15%-20% and with leading roles at AT&T, Sprint and Verizon, we see Alcatel-Lucent as a beneficiary and a share gainer over the longer term on a global basis
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