HQ:BUY rating and $63 tgt
Excerpts by Chase Hambrecht & Quist follow:
We are maintaining our BUY rating and $63 price target, which is based on a
sum-of-the-parts valuation. While it is clear that the company is losing
share in the near-term to Nortel Networks (NYSE: $82.50-NT, Strong Buy) and
others, and it faces difficulties in its core circuit switching business, we
believe these problems are fixable. Despite the flattish performance of the
circuit switching business, and the tardy introduction of new products in
higher growth areas, the company has been able to post healthy revenue gains,
and is expected to post another 20% top-line increase in FY2001. We believe
the company's exceedingly strong relationships with its customers has helped
support this growth and should continue going forward. Furthermore, ongoing
product development from Bell Labs and the ramp of new offerings should help
the company broaden its footprint in higher growth areas, such as optical,
wireless and Internet protocol (IP). We also believe future acquisitions
should help expand the company's product offering.
Outlook by Product Segment and Geography
With the announced spin-off of the Microelectronics business, scheduled to
take place next calendar year, management will be able to focus solely on its
Service Provider Networks business, which is primarily made up of products in
four segments: circuit switching, optical, data networking and wireless.
Circuit Switching
Circuit switching posted a 1% gain in the quarter, and is expected to be
essentially flat going forward. This is one of the biggest concerns for the
company, as circuit switching has historically represented the largest
percentage of revenues, and has been one of its highest margin products.
Circuit switching accounted for 16% of total revenues for the fiscal third-
quarter, down from approximately 22% a year ago. Circuit-to-packet gateways
and "softswitches" have cannibalized these revenues to date. Lucent has had
some success with its 7R/E product line, but it has not announced a true "next-
gen" packetized voice solution. We believe the circuit-switching business
will be essentially flat for the fiscal fourth quarter, and for FY2001,
reflecting the product segment's maturity. Therefore, as a percentage of
sales, the circuit switching business is expected to remain below its
historical average of 20%, most likely closer to the 16% in the most recent
quarter, as faster growing segments represent a larger portion of sales.
Optical Products
The company was slow to introduce products in the optical arena, and missed
the product cycle in 10G systems, causing it to fall further behind optical
systems leader Nortel. The company has made up some ground in optics,
shipping $250 million of 10G products in the fiscal third quarter, and is
expected to triple this amount in the fiscal fourth quarter as the ramp up
accelerates. However, in order to remain competitive, Lucent has been forced
to sell its 10G products at margins far below the company's average. We
believe the optical products group can grow approximately 30-40% in the long-
term. We believe further product development internally and from
acquisitions, such as the recent acquisition of Chromatis, should help the
growth rate move closer to that of industry leaders.
Data Networking
The data networking group has been experiencing tremendous growth, including a
60% increase in the most recent quarter. Included in this segment is the
Stinger DSLAM, which has benefited from the rapid deployment of xDSL service.
Additionally, the Ascend acquisition has proven to be successful, as demand
for ATM switches has remained robust. We believe the softspot in this segment
is the company's lack of new products in IP. For instance, we believe the
company's core IP router has not made any meaningful headway in the market.
We believe the data networking group should account for 10-15% of total
company sales, and can grow at 40-50% year-over-year.
Wireless
In wireless, the company is gaining a growing presence, led by its leading
position in CDMA and TDMA. In GSM, the company has been among the pack
chasing leader Ericcson. The company has historically built wireless
solutions internally, and has thus far been successful. We believe the unit
can continue to grow at close to 20%, in line with the market.
Domestic Revenues
Domestically, the company has been able to grow its business over 20%,
including a 21% increase in the fiscal third quarter. We believe this robust
growth rate is built on the company's exceedingly strong relationships with
customers. The Service Provider business in the fiscal third quarter was
approximately 72% domestic and 28% international, but should return closer to
a 65/35 split as the international business begins to pick up.
International Revenues
Internationally, the company posted growth of 4%, which would have been
greater than 22%, excluding the ramp down of a large project in Saudi Arabia.
This project is expected to negatively impact international sales for the next
two quarters, after which point overseas sales return to more normal levels.
Strengths
One of the key strengths for Lucent has been its strong relationships with
existing customers, which has helped it manage healthy revenue gains, despite
a lack of momentum in new products and a slowdown in its core circuit
switching business. We believe these strong relationships will remain
important in maintaining the robust revenue growth of the past few years.
Additionally, many of the company's new product offerings are in the early
part of their life cycles. We believe these new products, and those of
acquired businesses, can help the company fix some of its near-term ailments.
Challenges
A major challenge for the company has been its dependence on the circuit
switching business, which is now forecast to post flat results for the
upcoming quarters. Despite efforts to diversify away from this business, we
believe that Bell Labs' product development has been unsuccessful in
developing new offerings in high growth areas, including IP and next-
generation solutions. Additionally, with the stock trading off significantly
over the past few months, the company's deflated currency make it more
difficult to complete acquisitions in high growth areas.Valuation
Lucent is currently divided into two segments: Service Provider Networks and
Microelectronics. Service Provider Networks accounts for approximately 80% of
the company's reported revenues, with Microelectronics comprising the balance.
Included in the valuation of Lucent is a valuation on the Enterprise
business, which will be spun off later this year. We believe the Enterprise
Business could be valued at about $11 billion ($3 per Lucent share), which
represents a price-to-sales multiple of 1.3x estimated CY01 revenues, in line
with comparable companies such as Aspect Communications (OTC: $21.00-ASPT,
Buy). We believe that the Microelectronics business should be valued at
approximately $145 billion (or $43 per Lucent share), based on an estimated
price-to-sales multiple of 17x our CY01 revenue estimate of $9 billion for the
Microelectronics group. Since Microelectronics has no direct competitors,
this multiple is derived by taking a blended average of comparable companies,
including JDSUniphase (OTC: $130.88-JDSU) for the optoelectronics portion of
the business and an average of Broadcom (OTC: $237-BRCM, Buy), Texas
Instruments (NYSE: $67.44-TXN, Buy) and Conexant (OTC: $36.94-CNXT, Buy) for
the Integrated Circuit business. Optoelectronics represents 25% of the
Microelectronics segment, while Integrated Circuits represent 75% of the
segment's revenues. We believe the Service Provider segment will contribute
$0.85 per share of our $1.40 EPS estimate for CY01. Applying a price-to-sales
multiple of 20x this estimate, or 1x the company's estimated growth rate,
yields a valuation of $17 per share or $57 billion. Based on this
conservative sum-of-the-parts valuation, we believe the Lucent shares should
be trading closer to $63.
Maintain BUY rating
We believe the company can leverage its strengths, most notably its strong
customer relationships, to overcome some of the short-term obstacles facing it
today. Although the company missed some opportunities in higher growth
categories, such as optical and IP, many new products are now in the early
stages, with the potential for others through acquisitions. Going forward, we
believe the circuit switching business will make up a smaller percentage of
the total pie, allowing newer products to drive the future growth of the
company. Based on the conservative valuation method outlined above, we arrive
at a target price of $63. We maintain our BUY rating on LU shares. |
