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%+.



Cisco Wants To Be #1 – Déjà Vu All Over Again

Cisco held its annual financial conference on December 7th and as expected, the company outlined its new plan to become more of a software and services company. I wrote about this twist on Cisco’s strategy on my blog “Cisco Pulling an IBM?” on November 19th.   While Cisco spent a good part of its analyst day talking about how it is best positioned to implement this new strategy, CEO John Chambers also put out the goal for Cisco to be the number one IT company in the world in the future.  What I found interesting about this statement is that Cisco first put this target out in the 2006-2007 timeframe in a prior financial analyst meeting.  At that time, Cisco had its “secret” spin-in Nuova developing the UCS blade server allowing Cisco to expand its addressable market within the IT industry from networking to also servers.  Cisco was also at that time initiating its entry into the consumer IT segment, which it later shutdown in 2011 post the failed 2009 acquisition of Flip maker Pure Digital.

Cisco backed off its aim to the be the number one IT company when the 2008/2009 recession led to a decline in Cisco revenues and earnings, and concern that HP was going to commoditize its traditional networking business hit the stock in 2010/2011.   Well now that the great recession is over and HP is viewed less likely to be a challenger to Cisco given the numerous problem the company is experiencing, John Chambers has re-launched the bold target to be number one.  In 2006/2007, Cisco had the expansion into servers and the data center market as its launch pad for being more than just a networking company.  Today, Cisco is using a more aggressive entry into software and services as the next frontiers for being number one.  Storage seems to remain an area of partnerships rather an acquisition for now, but that could change depending on what EMC decides to do in the future with regard to any broader efforts in the networking market.

In my view, Cisco is better positioned in the networking industry than it was a couple of years ago as primary large competitors HP, Huawei and Juniper are less of a threat.  HP has had many corporate issues and a failed overall strategy to date, Huawei’s success in entering the Enterprise market has shown little progress outside of China and Juniper is spread thin and faces niche competitors in addition to Cisco in areas such as security and switching.  The improved competitive standpoint in networking and a much stronger commitment to capital returns to shareholders via a higher dividend yield than the past has make Cisco stock a safer place to be these days than the past three years.

While Cisco stock may be safer today than in the past three years, I think its still a long shot for Cisco to fulfill the number one IT company goal given IBM is basically already the de-facto number one IT company today with a strong suite of software and services, trust by corporate CIOs and a very focused and consistent strategy.  I don’t see IBM bowing to Cisco’s new goal to be number one.  In addition, other large traditional IT companies like Oracle and EMC and new challengers to the traditional IT model like Amazon, Apple and Google are all aiming to capture a larger share of corporate IT spending.  So until proven otherwise, Cisco’s claim that it wants to be number one in IT sounds like déjà vu all over again to me.  Given John Chambers is likely to retire within the next 3-4 years, the ultimate outcome of this goal is not even likely to be known when he departs after a long and successful role as CEO since 1995.


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….