Is U.S. Telecom Capital Spending Going Up in “Spectrum”?

Over the past couple of months several technology companies with meaningful exposure to telecom capital spending in the United States including Adtran, Ciena, Juniper and Procera have provided cautionary outlooks in their respective businesses. Most of the companies, analyst and press commentary on these earnings warnings primarily point to the impact of the AT&T Domain 2.0 vendor qualification process (including the associated architectural shift and additional pricing pressure it has brought to the industry), the pending consolidation of the some of the larger US telecom/PayTV operators (e.g. the AT&T/DirecTV and Comcast/Time Warner Cable deals) and a more front end loaded capital spending environment in the US than normal in 2014. While all of these factors are likely key contributing factors to the recent disappointing earnings of the technology companies exposed to US telecom capital spending, I also believe that pending wireless spectrum auctions in 2014 and 2015 are factors that have not received as much attention in the press and should be considered.

Wall Street analyst reports have suggested that the wireless spectrum being auctioned by the FCC in the AWS-3 auction in November 2014 is likely to cost the winners in the auction from $10-$15 billion with AT&T and Verizon likely being the major winners in this auction. To put this potential spectrum spending in perspective, AT&T and Verizon combined have an annual capital spending budget (both wireline and wireless capex) of about $36-$37 billion in 2014. Thus, if AT&T and Verizon spend a combined $9 billion in the November spectrum auction, it would represent about 24% of their combined capital spending plans for 2014, which is fairly significant percentage.

Another spectrum factor that potentially may impact capital spending in the short to intermediate term is the planned FCC Broadcast Television Incentive Auction, which the FCC estimates will take place in mid-2015. This spectrum auction is unique as the FCC plans on using free market forces to motivate existing broadcasters that own the spectrum to sell it in an auction format on a voluntary basis. Since the spectrum auction will be on a voluntary basis, its difficult to predict the potential timing, outcome and spending for the spectrum. Wall Street analysts, however, have written that wireless operators could pay as much as $34-$48 billion in the 2015 incentive auction for spectrum with AT&T and Verizon potentially spending a combined $21-$24 billion. Thus, if AT&T and Verizon combined spend about $9 billion and $22.5 billion in 2014 and 2015 respectively for wireless spectrum, this would represent about 43% of their combined overall capital spending budgets for the two years 2014 and 2015.  The following table shows how the potential spectrum costs in 2014 and 2015 compare to the overall US wireless industry capital spending budgets.

Estimates 2014 2015
AWS-3 Auction $10-$15 Billion
US Wireless Capex $34.1 Billion
AWS-3 Auction as a % of Capex 29%-44%
Broadcast Incentive Auction $33.6-$48 Billion
US Wireless Capex $34.5 Billion
Incentive Auction as a % of Capex 97%-140%

Source: Company reports and UBS Investment Research

Wireless operators have many cash pressures on their operating cash flow including network related capital spending, dividends, share buybacks, acquisitions and spectrum purchases.   Given the potential significant amount of spectrum purchases expected in 2014 and 2015 in the US, allocation of funds to spectrum spending by wireless operators may be another key factor that has led to weaker than expected network related capital spending, thus, resulting in weaker than expected earnings outlooks for certain technology companies. If one thinks about competing for cash outlays, deferring capital spending on equipment and allowing the network to run “hot” on a short-term basis, if possible, seems rational and plausible when such a large cash outlay is likely going to be needed for upcoming spectrum auctions. Network planning could also be potentially impacted as wireless operators have some uncertainty as to their spectrum assets pending the outcome of the auctions, which also could be impacting some spending in the network.

 

Be Careful What You Wish For

Wall Street has generally focused its research and analysis on how SDN will impact the technology sector. I have also expressed my views on this topic in prior blog posts and have generally taken the view that Layer 4-7 appliance companies may be most at risk as such appliances will be replaced by software applications, merchant silicon semiconductor companies may be poised to benefit as replacement cycles compress for networking equipment once the control plane is detached from switches, and the jury was still out on traditional switching/routing companies depending on how these companies maintain some level of software differentiation over emerging “white box” networking suppliers.

Last week I attended the OFC/NFOEC optical conference and walked away with some additional elements of my evolving SDN investment thesis.  In particular, while traditional telecom operators should benefit from the potential benefits of deploying SDN in their network, they may be also be at risk as SDN will move the value away from the physical network to the application layer where differentiation will be determined by using software for service creation.  While traditional telecom operators are clamoring for SDN as a way to reduce vendor lock-in, lower network cost and enhance service creation, I am not yet sure how well they will compete against software-centric rooted large data center operators like Google in cloud computing services.  Thus, as the value moves away from the network to the software layer, SDN may actually be a threat to traditional telecom operators.  Companies that can help traditional telecom operators through this transition to allow them to better compete vs. software-centric data center operators, will ultimately derive significant value in the financial markets in my view. 

While OFC/NFOEC is supposed to be a conference specializing primarily on optical communications, SDN permeated several of the presentations and seminars.  What I found interesting in several of these presentations was the contrast of how large data center operators like Google and Facebook talked about their specific traffic patterns and resulting approach to building out their data centers and network and how they plan on using SDN in this regard vs. how traditional telecom operators discussed the same topic.    The following table shows some general initial takeaways I had from these presentations.

Attribute

Software Centric Data Center Operator

Traditional Telecom Operator

Traffic Mostly machine to machine Mostly end user driven
Hardware Disposable Asset Long Term Asset
Software Core competency Bundled By Vendor
Network Protection Algorithm Focused Network Focused
Benefits of SDN Service creation

Reduce complexity

Reduce cost

Lower cost

Remove vendor lock-in

Service creation

Let me reflect on a few points on the above table.  Large data center operators like Google and Facebook are fundamentally software companies while traditional telecom operators are generally not.  The ultimate virtualization of the network layer, which is a key objective of SDN, will make software more of a differentiator between data center operators than it is today and could further differentiate data center operators in business and cloud computing services vs. traditional telecom operators in the future.

For example, a large data center operator at the conference talked about how they replace their servers every 18 months in their data centers as it is more cost effective for them to purchase new servers than to run their data centers on older servers.   Now I am not sure what the replacement cycle for servers are in data centers are large telecom operators, but the mindset of hardware being disposable is not typically embedded within the culture of traditional telecom operators.

Another example that resonated with me at the conference was how several telecom operators (and data center operators) talked about how optical transport cost is now about 80% of the network core capital spending costs vs. 20% for routers whereas several years ago the percentages were exactly the opposite.  In addition, some of telecom operator presentations also talked about how network protection in the optical core sometimes equates up to 50% of the network cost.  So, if routing is becoming a much lower relative cost in the core than optics, why are telecom operators putting so much focus in SDN presentations on vendor lock-in within Layer 3 of their network? Clearly all types of cost reduction should be pursued and attacking 20% of the cost is still important, but if separation of the control/data plane in Layer 3 is only going to address 20% of your cost, perhaps there should be more focus on industry standards for optical layer control protocol (e.g. extension of Openflow to the optical layer) and API software development that attacks network utilization and restoration.

So in summary, my main conclusions from the OFC/NFOEC conference in relation to the evolving SDN market are:

  1. While traditional telecom operators will benefit from SDN, they may also be at risk given a more software centric culture and pedigree at certain large data center operators.  Companies that can help traditional telecom operators becoming more software savvy will likely become valuable companies.
  2. Optics is becoming a larger part of the network cost problem than routers for both data center and telecom operators.  Hardware and software companies that attack and solve this problem will likely become valuable companies. Although funding for such hardware initiatives is not in vogue, hardware companies could include merchant silicon companies for coherent optical DSPs or companies that innovate on integration of optical components (e.g. silicon photonics, indium phosphide).  Software companies could include companies that solve high costs associated with network utilization (given the very wide spread in network traffic between peak and average traffic loads) and network protection.
  3. While switching remains an important cost problem, it presents a much bigger problem within the data center in terms of network agility and an obstacle to service creation.   Data center operators want switching solutions that scale horizontally with the control plane disaggregated.

Oracle Goes Telecom II

Well it seems Oracle is serious about expanding its business with telecom operators as it announced today it will acquire diameter routing and SS7 signaling specialist Tekelec. This complements and adds to the announced acquisition of Acme Packet, which was announced just over a month ago on February 4th.   It looks to me that Oracle clearly wants to expand its business with telecom operators, but it is doing it in a very complementary and focused way through these two acquisitions.  So far, both acquisitions of Tekelec and Acme are providing Oracle relatively high margin revenues in the telecom market in the control, policy and management layers of the core of telecom networks.  This complements Oracle’s database revenues in telecom networks focused on business operations, end customer engagement and applications.

My two quick observations on Oracle’s recent telecom acquisitions are as follows:

Staying Focused, Watching SDN For New Entry Points: So far, Oracle has stayed away from entering network infrastructure products that actually carry network traffic and end user information (e.g. routers, switches, optical, etc.).   Oracle seems very focused on staying within the network management, policy and control supervisory layers of the network and not entering classic network infrastructure.  I suspect Oracle will stay true to this plan of action. In the future, however, as SDN and network virtualization develop as new markets, I would expect Oracle to look at taking advantage of this technology disruption as certain hardware based infrastructure functionality becomes software based running on the network core as potential future revenue opportunities.

Offensive and Defensive Acquisitions Given Cisco’s Software Aspirations: While Cisco and Oracle are not that competitive today, Cisco’s ambition to be more of a software company clearly suggests the two companies are more likely to compete for acquisitions and new markets in the future.  I believe Oracle has stepped up its acquisition efforts in the telecom vertical to gain a stronger foothold in telecom policy, control and management core as both an offensive move to expand its addressable market, but also as a defensive move against Cisco as it looks to expand its software business.  “Big IT” business models are converging and will continue to converge in the next several years.  As an example, five years ago neither Cisco nor Oracle sold servers, now they both do.  As network and storage virtualization open up new software markets for new entrants like Oracle and Big Data Analytics potentially open up new software markets for new entrants like Cisco, convergence among “Big IT” players Cisco, EMC, HP, IBM and Oracle is likely to continue to continue.

Telco Capex, Big IT War Chests and Optical Component Stocks

I have been traveling quite a bit these past couple of weeks and working on some consulting projects, but wanted to provide a quick update on topics I have been writing about in the past few months.

Telco Capex:  As a continuation of prior blog posts since November of last year, I continue to believe telecom capital spending trends will be positive in 2013 and the momentum still remains positive.  Telco operators are often like Wall Street in that they follow the “herd mentality”, namely, they tend to follow each other in either being offensive or defensive in their respective spending plans.  The setup for a favorable capital spending cycle in 2013 seemed good given the challenging 2011 and 2012 spending environment led to a period of underinvestment going into the build-out cycles associated with LTE, Data Center connectivity and residential broadband upgrades.  While 2011 and 2012 were years of preservation of capital and a defensive posture, 2013 and perhaps 2014 will be years where telecom operators go on the offensive by investing in new technologies in an attempt to gain share and offer new services.  I have already written about how we have seen such offensive moves in the US (e.g. AT&T and Sprint) and Europe (KPN, Telecom Italia, and DT).  Last week, we got the important endorsement of this trend from China Mobile, the wireless operator with the largest wireless capital spending budget in the world.  China Mobile announced its 2013 capital spending budget will be up 49% over 2012, well above analyst expectations of a 23% increase.  I continue to be favorable on telecom equipment stocks given this ongoing positive momentum in capital spending in 2013 and view Ericsson as a reasonable way to play this cycle.   It is important to realize here, however, that most telecom equipment stocks are cyclical, not secular, stocks. Ericsson is up over 50% from the bottom and is already discounting the recovery in telecom capital spending. The “easy money” likely has been made in the stock, although I still think there might be another 10%-20% upside from here.

Big IT War Chests: This past week Salesforce.com raised about $1B through a convertible note while EMC/VMWare announced plans to IPO their Pivotal Big Data/Cloud initiative sometime in the future.  I view both of these events as ongoing evidence how Big IT companies (e.g. Cisco, IBM, Oracle, EMC/VMWare, etc…) are gearing up for an M&A cycle to better position each of them in the battle for Everything Cloud (e.g. Big Data, SDN, Data Center Virtualization etc…).  Salesforce.com already has about $1.8B in cash/investments and generates over $500m a year in free cash flow. The company also has a very high PE multiple of almost 90x 2013 earnings.  Acquisition targets, especially private companies, may find taking Saleforce.com stock as too risky given the high multiple and would prefer cash.  I believe Oracle’s recent acquisition of Eloqua (announced in December) perhaps accelerated Saleforce.com’s desire to have a greater cash balance to have a greater war chest for future acquisitions. In order for Saleforece.com to compete for such acquisitions against more cash rich companies like Oracle, Cisco etc…, they needed to increase the cash balance.  EMC/VMWare on the other hand have the other problem.  In the past, VMWare provided EMC a high multiple currency to make stock based acquisitions, while EMC and VMWare both have had ample cash to make cash based acquisitions. The recent selloff in VMWare stock post reporting 4Q12 results, however, lowered VMWare’s forward P/E multiple to about 20x vs. the historical average of about 35x-40x.  The announcement of the potential IPO of Pivotal in the future helped both stocks and ultimately will provide EMC/VMWare another high multiple stock to make stock based acquisitions.    With Cisco aiming to be more of a software company, Oracle trying to expand more in the telecom space (e.g. Acme Packet acquisition) and all the Big IT companies striving to be leaders in Big Data, SDN and Everything Cloud, we are likely to see an increasing M&A cycle in 2013 and 2014 and these companies are getting their respective war chests ready.

Optical Component Stocks: Silicon Photonics vs. The Cycle: In a prior blog post, I expressed some concern on optical component stocks (e.g. JDSU, FNSR etc…) given the technological threat posed by the emerging Silicon Photonics technology.  I am still concerned about how Silicon Photonics initiatives at Intel and others as well as vertical integration efforts by large buyers of optical components like Cisco (through the acquisitions of CoreOptics and Lightwire), will impact future valuations and stock performance of optical component stocks.  While I still have this concern, the near term cycle of optical spending is likely to trump the longer-term risk of Silicon Photonics in my view.  In a way, Silicon Photonics will be to optical component stocks in 2013 like SDN was to networking stocks in 2012.  As a reminder, Cisco’s stock suffered in 2012 as SDN became a hot topic and VMWare acquired network virtualization specialist Nicira.  While SDN is still a hot topic, Cisco’s stock has performed well in the past several months as the company has beaten estimates, preserved its gross margin and SDN is not viewed a near term threat.  I think the optical cycle is recovering and we should see good spending trends in optical systems and components in 2013, as 2013 will likely be a recovery year after a difficult 2012. In addition, telecom capital spending trends continue to show positive momentum in 2013 as I mentioned above.  Thus, while there will continue to be a lot of discussion and analysis on how Silicon Photonics will impact optical component suppliers in the future, 2013 should be a year where optical companies beat Wall Street estimates.  I think such a playbook will allow optical stocks to further appreciate for a few more months.  Like telecom equipment stocks, optical component stocks are cyclical and they all have already appreciated significantly off the bottom.  Thus, upside from current levels may be limited and the stocks remain very risky and volatile. We should get further information on the status of the optical cycle and the threat of Silicon Photonics this week at the annual fiber optic OFC trade show, which I plan on attending.

Disclosure: I currently own Ericsson and JDSU mentioned in this blog.  NT Advisors LLC may currently and in the future solicit any company mentioned in this blog for consulting services.

What To Do With ALU?

In prior blog posts over the past few months I have been positive on technology stocks for 2013 given low relative valuations to the overall market and my view that IT and telecom capital spending will recover in 2013.  In particular, I have liked Alcatel-Lucent and Ericsson as a play on telecom capital spending and increased concern over Huawei as a security threat in the US (and some other markets), and recently Hewlett Packard given extreme negative sentiment, favorable cash flow and a low valuation, which was amplified by the Dell LBO valuation metrics.

While I remain positive on technology to outperform this year, Alcatel-Lucent has become a bit more challenging of a stock in my view.  I think the stock could still work over the course of the remainder of 2013, the next 2-3 months could be volatile and the stock could decline until after 1Q13 results are reported.  I base this on the new dynamics that have become public since the company reported 4Q12 results on February 7th, namely:

–       A new CEO was announced and he will not take over until April 1st, thus, potentially distracting the company during this interim period in 1Q13 as well as the new CEO potentially resetting expectations lower given new CEOs often seek to “lower the bar” when they take over a struggling company

–       Press reports about a potential combination with competitor Nokia Siemens Networks (NSN), which in theory could be positive but in reality may be very difficult to implement and execute

–       Press reports that the French government may take a stake in ALU to help secure the future of the company and its patent portfolio, which I think would not be in the best interest of shareholders

Positive on New Executive Announcements

I think the new CEO selection of Michel Combes seems like a good one given his background in the telecommunications industry at Vodafone and France Telecom and more importantly his reputation as a cost cutter, which is what ALU needs the most right now.  I think it is also positive that a new CEO was selected quickly, rather than long drawn out process.  I believe he will be well received by investors when he takes over the company on April 1st.  In addition, I strongly favor the selection of Jean Monty for the new role of Vice Chairman of the Board of Directors. When I was a Wall Street analyst, I found Jean Monty as an excellent CEO as he led the turnaround of Nortel in the 1990s after Nortel had underinvested in R&D and was suffering market share loss and degrading customer relationships.

While I am positive on the two new executive announcements, this first quarter could be a very challenging one for ALU.  The new CEO does not take over until April 1st.  The company could lack focus on trying to deliver the best financial results as possible given uncertainty on what the new CEO will do when he takes over on April 1st.  In addition, the first quarter of every year tends to be the most challenging for ALU and in the industry as a whole.  Thus, there could be some pressure on ALU shares until 1Q13 results are behind the company in my view given these transitory issues.

 Merger With NSN Good Theory, But Probably Difficult in Reality

The press has reported that ALU may be seeking a merger, investment or some other partnership with European competitor NSN. In theory, a merger with NSN might look attractive given both ALU and NSN are competing against much larger wireless infrastructure suppliers Ericsson and Huawei.  Combining forces would reduce competitive pricing pressure and provide more scale to compete against these two larger companies.  In reality, however, merger of equals in the telecom infrastructure usually results in 2+2=3, not 4 or 5.  The reason is that rationalizing duplicative product lines (wireless infrastructure in this case) is not easy, as customers do not typically accept products to be discontinued due to a merger. Thus, duplicative products and associated costs linger much longer than anticipated.  The other main issue in merger of equals is the cultural clashes of the two companies and political infighting that take place post the merger.  In fact, both NSN and ALU experienced these issues when each entity was formed in prior mergers (i.e. Alcatel merging with Lucent and Nokia Networks merging with Siemens infrastructure).

In addition to the challenge of achieving synergies being difficult in a merger between ALU and NSN, the appetite of NSN to go through such a restructuring effort after it is far along on its own restructuring plan would seem low to me.  NSN is well along in its restructuring into a primarily wireless infrastructure company after selling most of its other businesses and downsizing the company’s workforce by close to 25% (e.g. Access business sold to Adtran, Optical business sold to Marlin Equity Partners, Microwave Transport to DragonWave and Business Support Systems to Redknee etc.).  These restructuring efforts have paid off for NSN as it has reported solid financial results in 2012.  Merging with ALU would require a long merger process followed by another couple of years of new restructuring.

Another problem in merging NSN and ALU is that NSN is not a public company and does not have its own stock.   It seems to me that NSN, if public, would have a higher valuation than ALU and be more of the potential acquirer or investor into ALU than ALU being the acquirer or investor into NSN.  NSN is much further along than ALU in its restructuring, and as a result is much more profitable than ALU with full year 2012 operating margin of 5.6% and 4Q12 operating margin of 14.4% vs. ALU full year operating margin of (1.8%) for 2012 and 2.9% for 4Q12.  In addition, NSN has been generating positive cash flow for the past several quarters while ALU burned cash in 2012.  The better profitability, cash flow generation and further restructuring progress at NSN, would likely result in a higher valuation for NSN than the current ALU valuation.  ALU currently trades at about 0.3x EV/Sales. Ericsson, the other global, large, profitable and publicly traded telecom equipment supplier, currently trades at about 1x EV/Sales. My sense is NSN would trade closer to the valuation of Ericsson rather than ALU (maybe 0.6x-0.7x EV/Sales as an estimate).

Given NSN would have the higher valuation than ALU, but does not have a public stock currency, either NSN would first have to be spun out as a stand alone company to obtain a stock currency or NSN parent companies Nokia and/or Siemens would have to put up the cash to acquire ALU.  A spinout is certainly a possibility, but that will take months to implement and it would be highly unusual for such a spinout to do a large acquisition right after the spinout.  I also think neither Nokia nor Siemens has the appetite for using their cash to acquire ALU.  In particular, I think Siemens no longer views telecom infrastructure as strategic and would be reluctant to provide any additional cash infusion to NSN so it could acquire ALU.  Siemens is more likely looking at monetizing its potential stake in NSN (e.g. about €4-€5 billion) rather than investing more into the JV to acquire ALU.  Nokia may want to maintain an ownership in NSN even post an spinout given there are some advantages in selling both mobile devices and infrastructure to telecom operators. Huawei is using this tactic more often, and I believe Nokia views NSN as a way of countering this Huawei sales approach.  There may be some other intricate financial means for NSN to acquire ALU than the two I mentioned above, but regardless of the method, it would be a challenging integration in my view.

French Government Involvement Not Likely In Shareholders’ Interest

Press reports also suggest the French government may seek to invest directly in ALU via the government’s Strategic Investment Fund.  This fund was used in the past to invest in other French based companies (e.g. Gemalto and Nexans SA) that the government viewed as critical to French competitiveness. I am not positive on a French government investment in ALU.  I think a key motivation of the French government to invest in ALU would be for job preservation in France (ALU employees about 9,000 in France), which would oppose the whole idea around cost reduction for ALU and not be in the best interests of shareholders.  For shareholders, I think it would better to see ALU go through a restructuring program much like NSN did over the past two years, rather than take an investment from the French government to preserve French and other European jobs.   As I mentioned in prior blog posts, ALU cannot remain in all aspects of telecom infrastructure, but should follow the path of NSN and focus where the company has scale and competitive advantage. Namely, I think ALU should focus on Access, IP Routing and Optical.

Disclosure: I currently own shares of Alcatel-Lucent, Ericsson and HP although I may look to sell my ALU position in the very near term given points I mentioned in this blog.  NT Advisors LLC may currently or in the future solicit any company mentioned in this blog post for consulting services.

Telecom Equipment Dynamics Remain Favorable

As I have posted in prior blog posts over the past few months, I have been generally positive on Alcatel-Lucent and Ericsson given my view these two stocks were under valued and that a cyclical bullish trade in these two stocks was likely given a better telecom capital spending environment would materialize in 2013.  This past week, three data points came to surface that continue to make me comfortable with this thesis.

  1. Telecom Italia announced it was cutting its dividend by about half, to help fund its capital spending plan for 2013-2015 to support needed network investments in both LTE and fiber based broadband networks.  Capex in each year in the 2013-2015 period would likely remain consistent with the 2012 capex level of about 3 billion.  While cutting the dividend to help fund capex is not ideal, the fact that a large European telecom operator is committing to a reasonably healthy capital spending outlook for the next three years is encouraging, especially for a Southern European telecom operator given the weak economic condition in that region.
  2. Telecom operator KPN of the Netherlands reported 2012 capex of 2.2 billion, at the high end of its guidance of 2.0-2.2 billion.  KPN is another European telecom operator that had cut its dividend in 2012, yet actually spent at the high end of its capital spending guidance.  More importantly, KPN announced that for 2013-2015 annual capex would be in the range of about 2.2-2.3 billion, suggesting capex in each of the next three years would be at the 2012 level or slightly higher. Once again, the drivers for capital spending would be the build out of its 4G wireless network and a more robust broadband wireline network.
  3. Sprint reported 4Q 2012 results Wall Street analysts significantly raised their 2013 and 2014 capex estimates from about $5.5-$6.5 billion per year to about $7.5-$8 billion per year.    This level of capex compares to $5.4 billion in 2012.  Clearly Sprint is planning to be aggressive with its capital spending given the planned investment by Softbank and Softbank’s desire to be major force in the US wireless market.

Europe Has Been Underinvesting; New Competitive Dynamics in the US

What I infer from these data points as well as the analysis of historical capital spending trends is that most telecom operators in Europe have been under-spending given the weak macro-economic conditions in the region as well as pressure to preserve current dividend payouts.  It seems to me that the mindset of European telecom operators might be changing from “preservation” to “growth” which in some cases is supporting dividend cuts in favor of capital spending in growth initiatives like 4G and wireline broadband initiatives.  In addition, the US market could be poised for a new competitive dynamic where the virtual duopoly of AT&T and Verizon will be challenged by a newly funded and aggressive Sprint and the re-emergence of T-Mobile as another wireless operator that invests for growth.  T-Mobile may not have long term aspirations like Sprint in the US and eventually may seek to sell itself to Sprint or another entity. But in the interim period of the next two years, T-Mobile will likely be more of in the investment mode in its network rather than a harvest/sell mode.

While I Remain Favorable, Telecom Equipment Stocks are Very Risky

The telecom equipment market is still a very competitive industry with aggressive pricing pressure.  A more favorable capital spending environment is certainly a positive, but does not ensure stocks in the sector will perform well.  While this is still a risk, I continue to think the bullish cyclical trade has not run its course and remain positive on both Alcatel-Lucent and Ericsson.  Alcatel-Lucent has additional risks of turning around negative cash flow performance since the merger of the two former companies and a sub-scale business.  Thus, it is a much riskier investment than Ericsson.

 Plot Thickens at ALU With A New CEO Search and Press Reports on NSN

In the case of Alcatel-Lucent, the company also announced it is looking for a new CEO.  The outcome of this CEO search will certainly be an important factor impacting the stock performance of ALU in the future.  The WSJ sites NCR current Chairman and CEO Bill Nuti as one potential candidate.  Bill has an accomplished career and I think would be a good choice for ALU.  On the other hand, the job of turning around ALU will be challenging for any new CEO as the company has a high cost structure, especially in Europe, and needs to focus its R&D in fewer areas of the telecom equipment market.  The high cost structure in Europe is a major over-hang, as typical severance packages in France and other parts of Europe require up to three years of salary when employees are downsized.   Large severance payments in Europe will make it difficult for ALU to successfully complete its restructuring in my view.  Thus, any new CEO, regardless of talent and vision, will have to somehow overcome this restructuring over-hang.

Another interesting French corporate development to watch that may or may not have implications for ALU is how the French government deals with similar cost and market demand issues at French auto manufacturer Peugeot.  Press articles discuss that the French government might get involved in the restructuring/turnaround of Peugeot to preserve the company and jobs in France.  Peugeot, however, employs significantly more people in France (about 100,000) than ALU (about 10,000).  In addition, there is precedent in the auto industry for governments to help struggling companies (e.g. the US bailout of General Motors), but we have not seen such support in the telecom equipment market (e.g. the Canadian government did not get involved when Nortel fell to bankruptcy).

Increasing the intrigue on the CEO selection and ongoing restructuring at ALU is another recent press report from Bloomberg indicating that Siemens would like to exit its 50% ownership of the Nokia Siemens Networks (NSN) joint venture with Nokia (Nokia owns the remaining 50% of this joint venture).  NSN has shown three good quarters in a row and is well down the road in its own restructuring plan.  Thus, it is not a surprise that Siemens would want out of the JV as Siemens has been exiting its telecommunications businesses over the past several years and NSN is now more of a stable entity.  Nokia likely wants to stay in the wireless infrastructure business as smartphone competitor Samsung is attempting to win business by bundling smartphones and wireless infrastructure equipment in several of Nokia’s markets.  According to the Bloomberg article, Nokia is considering buying Siemens’ stake directly or in a partnership with ALU.   If in-fact ALU would end up being a part owner of NSN, this would likely be a positive for both ALU and NSN as they would be partners rather than competitors in the wireless infrastructure and services markets.   Given both are distant players behind Huawei and Ericsson in the wireless infrastructure market; a partnership between the two would help both companies. This of course assumes, that ALU is able to fund a purchase of a partial ownership in NSN and the ability for both ALU and NSN to implement further restructuring in their respective wireless equipment and services businesses that would likely result from a partnership between NSN and ALU.  The other interesting angle in a potential partnership between ALU and NSN would be whether NSN would begin favoring ALU for IP routing equipment instead of Juniper Networks, its long time partner for IP routing.  That could be another positive for ALU to come out of such a partnership, besides better competitive dynamics in the wireless infrastructure and services markets.

Disclosure: I own shares of Alcatel-Lucent and Ericsson mentioned in this blog post.  I currently and in the future may solicit any company mentioned in this blog for consulting or advisory board services for NT Advisors LLC.

 

 

Return of the Telecom Jedi?

I continue to be positive on large telecom equipment suppliers Ericsson and Alcatel-Lucent.  The main premise behind my positive view is the telecom infrastructure industry is a cyclical industry, and we are likely to see a recovery of capital spending by telecom operators in 2013. This recovery in telecom spending, combined with relatively low valuations for equipment companies like Ericsson and Alcatel-Lucent, should allow these stocks to have good relative performance in 1H 2013.

In addition to this primary thesis on these stocks, I also point to two other recent data points.  First, the strong recent operating results and profits by the telecom equipment infrastructure business at Nokia Siemens Networks (NSN).  As mentioned on a prior blog post, NSN has reported better than expected profit margins in the past three quarters and seems to be executing well on its restructuring plan.  Secondly, I believe the momentum of Chinese based equipment suppliers Huawei and ZTE is diminishing (at least for now), which should bode well for Alcatel-Lucent, Ericsson and others.  This is an important point as Huawei and ZTE have been massive market share gainers and price setters in the telecom infrastructure market over the past decade, which negatively impacted the entire sector.

Both Huawei and ZTE provided financial updates on their 2012 results in the past couple of weeks, which showed slowing momentum in terms of further market share gains and achieving their respective 2012 revenue targets.  According to the Financial Times, Huawei announced in January revenues of about $35 billion for 2012, but that was below the Huawei target of $38.7 billion it was discussing as late as September of 2012.   Over the past couple of years, Huawei has been seeking to achieve its long-term growth targets by entering the new markets of Enterprise Networking and Mobile Devices.  While the company seems to be doing well in Mobile Devices at the low end of the market, Huawei does not seem to be hitting its targets in the Enterprise Networking market.  These new efforts are also spreading the company thin in my view and puts Huawei on a multi-front competitive battle with Cisco and HP in enterprise networking, Samsung in mobile devices in addition to traditional competitors like Alcatel-Lucent, Ericsson and NSN in telecom infrastructure.

As for ZTE, the company pre-announced lower than expected results for 4Q12 last week.  Not only were the results lower than expected, but also some equity research analysts now believe ZTE’s market share gains in the international telecom equipment market have stalled.  Below is an exert from a research report on this topic from UBS Investment Research:

“After large-scale staff layoffs and the closure of a few representative offices in

overseas markets, we believe ZTE’s growth in the overseas equipment segment

will slow significantly. Our channel checks suggest the pipeline for new

contracts is limited. In the longer term, we believe ZTE’s withdrawal from some

developed markets means the prospect of ZTE gaining a top-three role as a

global equipment vendor by overtaking Nokia Siemens Networks (NSN) and

Alcatel-Lucent has become quite slim.”

Source: UBS Investment Research Report Dated 1/28/13

 

Disclosure:  I currently own shares of Alcatel-Lucent, Ericsson, HP and Cisco all of which are mentioned in this report.  I also may solicit any company mentioned in this report as a potential consulting client for NT Advisors LLC.

 

 

 

 

Will Alcatel-Lucent Follow the Nokia NSN Playbook?

Today, Nokia pre-released 4Q12 results that were better than the copmany’s prior guidance and analyst expectations.   The stock is up about 20% so far this morning given the combination of Nokia beating expectation, having a low valuation and the stock being under-owned by investors and under-loved by analysts with a low valuation.  While Nokia is mostly known for its device/handset business, a big part of the earnings composition and surprise today is the performance of the Nokia Siemens Networks (NSN) division (a joint venture between Nokia and Siemens).  In particular, NSN represented about half of Nokia consolidated sales (although keep in mind, Nokia owns about 50% of NSN, so prorated impact to Nokia’s profits are about 50% of reported NSN operating profits) and the vast majority of operating profit in 4Q12 (even when adjusting for the 50% ownership of the JV).

This is the third quarter in a row that NSN has performed better than analyst expectations.  What I find relevant in the recent NSN results is whether there is a read through to Alcatel-Lucent, another legacy telecommunications equipment supplier that has been suffering.  As I wrote in a prior blog on December 17th, I am positive on the Alcatel-Lucent stock (ticker ALU) given what I believe to be an improving capital spending environment in 2013, a low valuation, an under-owned/loved stock and the recent debt financing the company was able to raise which dramatically reduced the risk of bankruptcy in the next two years.  I find the NSN results and business execution relevant to ALU and continue to be positive on the shares.

What I find most compelling in the NSN results in the past couple of quarters and in particular the 4Q12 preliminary results, is the improving profit margins of the company.  NSN has targeted an operating margin of 5%-10% and delivered a 4Q12 operating margin in the 13%-15% range. While fourth quarter operating margins in any year are typically much higher than the full year average given the favorable seasonality of the telecom equipment in the fourth quarter, NSN continues to outperform on its operating margin guidance.  I think a good part of this outperformance is the company’s restructuring program including its services business.   In particular, NSN is in the middle of reducing 17,000 employees, has announced plans to sell its Optical unit to Marlin Equity Partners, has sold its Access business to Adtran and is aiming to be a more focused company specifically in the mobile broadband infrastructure market.  NSN’s profitability seems to be benefiting from this new focused strategy.

Alcatel-Lucent in my view is probably 6 to 12 months behind NSN in terms of its restructuring and focused strategy but shares several of the problems NSN had a year ago, namely, a bloated cost structure primarily in Europe, unprofitable services contracts and being in too many businesses with lack of scale.  I hope the ALU management team is watching at how the NSN restructuring actions has led to improved profitability and share price appreciation.  I continue to think that ALU should focus on fewer businesses and be more aggressive in cutting its high cost structure in Europe. NSN shows, that while such a course of action is painful, it can be done and generate great results for shareholders.  In particular, I have written in the past that ALU should consider selling its mobile infrastructure and enterprise networking businesses and become more focused on high market share business like Routers and Optical, after which the company could focus on margin improvement.  Whatever the course of action the company choses to take, I still believe that the stock could be a strong performer if we see real action in restructuring in Europe, more focus in less business area and an improving telecom capital spending environment.

Disclosure:  I do currently own shares of ALU, but do not own or plan to own shares of NOK in the next few days. 

Why I Am Long Alcatel-Lucent (ALU)

I recently became long the shares of Alcatel-Lucent and believe the stock could be a strong performer in the next few months.   I also believe the rational for being positive on ALU also holds true for the telecom equipment sector as a whole, although ALU likely offers a higher relative return, although with more risk, than other stocks in the sector.   I believe that combination of the telecom equipment sector being out of favor for most of 2012 and an improving and no longer weakening telco capital spending environment, will make for solid stock returns for telco equipment suppliers in 4Q12 through 1H13.  I think high beta names like ALU, are likely to show the most significant returns over this period.

Specific to ALU, my main two points on becoming positive on the shares are the postponement of any bankruptcy risk and the improving telco capital spending environment.  While I am not sure if ALU will ever hit their 2015 financial targets, these targets are so far out into the future that they are not likely to be that relevant to the stock in the next six months if the risk of bankruptcy has been delayed by a couple of years and telco spending is showing signs of improvement.  ALU is still a very risky stock, but it appears to me the upside potential outweighs the downside potential over the next six months.

Bankruptcy Risk Dramatically Reduced: On December 14th, ALU secured a 1.6B Euro credit facility.  While the company had to pledge part of its patent portfolio and according to the press its “crown jewel” IP routing business to secure this credit facility, the new facility will allow ALU to financially move forward with its 1.25B Euro cost reduction program.   While not eliminating the potential of a bankruptcy in the future, this new facility delays this potential outcome for several quarters if not 2-3 years.   Even one of the sell side analysts that is still negative on ALU shares wrote that this new credit facility “extends the window of survival for the group from 2015 to 2018.”  Well, if the risk of bankruptcy has been extended to 2018, and sentiment is very negative on the shares, it seems to me that the stock can work for the next 3-6 months if anything positive happens beyond the new credit facility.

Telco Capex Is Cyclical and Poised to Improve:  I believe ALU, and other telecom equipment stocks, will have a positive first six months of 2013 as telco capital spending is poised to improve after a difficult 2012.  This is especially true in the US mobility market.  The acquisition/investment in Sprint by Softbank, the T-Mobile/PCS merger and the increased capital spending plans outlined by AT&T at its analyst day in November clearly suggest that the Verizon/AT&T duopoly in the US Mobility market is about to be challenged.  This challenge will partly be in the form of strong network investment by the challengers Softbank/Sprint and T-Mobile/PCS.  Telecom equipment stocks tend to do well when major telcos are investing heavily to win share against each other.  After showing a flat year in spending growth in 2012, the US mobile market is likely to show capital spending growth of at least 10% in 2013.  We are also even seeing signs of wireline capital spending stability by major telcos in both the US and Europe. Specifically, both AT&T and Deutsche Telekom have outlined upgrades to their wireline networks in 2013 that will lead to flat to growing capital spending growth in their respective wireline networks, after declining in 2012.   Overall, both AT&T and DT will grow total capital spending in 2013 over 2012 on the order of 15%+.

 

 

Marlin Attempts A Roll-Up Strategy In the Optical Market – Good Luck!

It appears Marlin Equity Partners, a private equity firm, is attempting to create a new Optical Systems roll-up company. Specifically, the company announced today that it was acquiring the Optical Systems business of Nokia Siemens Networks (NSN). This follows the announcement in October of the acquisition of optical switching company Sycamore Networks.  Marlin is quoted in the press as saying it wants to act as a consolidator in the optical market and buy more assets.  Thus, it is likely they will look to acquire more optical in assets in the future.

Strategy Will Be Challenging

My take on this strategy is that a successful outcome will be difficult for Marlin. While the long-term historical growth rate in the optical systems industry is fairly robust at 6%-7%, actual annual growth rates are very volatile around the average.  In addition, gross margins in the optical systems market have remained in the 35%-45% range for over 20 years with high R&D costs required to maintain innovation limiting overall net profit margins.  This has led to very few optical systems companies showing consistent profitability and free cash flow generation over time.  Finally, Marlin will only have a combined global market share of about 4% with NSN and Sycamore.  With Chinese competitors Huawei and ZTE of both having materially higher share of about 20% and 12% respectively and technology leaders Alcatel-Lucent and Ciena having shares of about 16% and 10% respectively, Marlin will be very challenged to obtain scale in the business.

Buying Cheap, But May Not Be Enough

The one advantage Marlin has in its strategy is that it is implementing this roll-up strategy at a time when optical system valuations are at the low end of the historical range in terms of price/sales multiples (e.g. Ciena is trading at about 0.8x sales vs. a 5 year range of 0.5x-3.5x) and my guess is they are not paying much for either NSN or Sycamore.  However, compiling 2nd/3rd tier businesses at low prices does not guarantee a great strategy.  I have yet to see a successful roll-up strategy of 2nd/3rd tier players in the communications equipment market (e.g. Zhone).   Marlin will also perhaps be challenged in quickly achieving cost reduction given a high level of European employees in the NSN transaction.  I am sure Marlin was aware of this prior to pursuing the deal, but even so, layoffs in Europe typically take a long time to implement and have high severance costs associated with them.   Look at all the issues Alcatel-Lucent is having in cutting headcount in Europe even as the company is burning cash consistently and has a troubled balance sheet.

Sign of the Times

We have also seen some recent attempts at buying assets on the cheap as part of rollup strategy this year in the sector including Adtran/NSN in the broadband access market, Calix/Ericsson in the broadband access market and Oclaro/Opnext in the optical components market.  Thus, Marlin is not alone in trying to take advantage of companies “throwing in the towel” in certain businesses and buying assets at low prices in an attempt to build scale and value over time.   I suspect this trend will continue given the ongoing slow capital spending growth in the sector and poor stock performance of equipment manufactures.  Companies like Alcatel-Lucent and Tellabs have already announced plans for layoffs, and closing/selling certain businesses within these and other companies over time is likely in my view

Adva or Fujitsu USA May Make A Good Fit For Marlin

For years as an equity research analyst there was constant speculation about private equity and other companies looking at rolling up the 2nd tier optical systems companies.  When Nortel’s optical systems business went up for sale in 2009 during the Nortel bankruptcy process, however, only Ciena and NSN (likely partnered with private equity at the time) actually bid on the assets.  The fact that no other private equity shop bid on the Nortel asset at the time and the lack of any other attempt to rollup the optical system industry since then I think is a sign that the actual implementation of such a strategy will be challenging.

Given that Marlin now appears ready to give the optical systems rollup strategy a shot, what other deals might be appealing to them?  NSN is strongest in long haul transport and Sycamore has technology in bandwidth management/switching.   Thus a metro optical company would make the most sense for Marlin. The two that come to mind here are Adva and Fujitsu’s US optical business..  Fujitsu is already partnered with NSN in the US market at AT&T.  The challenge with acquiring the Fujitsu US optical business is that the R&D is done in Japan, which will complicate the integration of both NSN and Fujitsu. Adva might be an easier integration given that the company is based in Europe, where most of the NSN R&D is centered.    It certainly will be interesting to watch….