Capex Continues To Surprise On the Upside

A key fundamental driver of the communications equipment industry and associated supply chain stock performance is the growth in overall capital spending by service providers, including wireless, fixed and cable TV operators.  Coming into 2014, the general expectation by Wall Street analysts was for 2014 to be a decent year of overall growth in capital spending on the order of 2%-4%, with the wireless component growing much faster in the 6%-9% range. The 2014 growth expectation was due to a ramp in spending in key markets like China given the expectation that LTE would be finally rolled out in earnest, Europe given operators were expected to start growing spending after a period of under-investment in the past few years and the US given wireless operators were expected to continue to grow spending to enhance network quality and expand LTE coverage.

After reviewing some of the key telecom operator 4Q13 results in these regions and their respective comments on capital spending plans for 2014, the general bias on 2014 capital spending by operators was generally to either maintain or raise capex expectations.  In addition to expected capex spending growth in wireless I mentioned above, we also heard better spending plans in fixed networks in the US from the larger three cable TV operators and in Europe by traditional fixed operators.

I continue to view the upward bias on 2014 operator capex as favorably for communications equipment and supply chain companies.  While several companies may benefit from this trend, I continue to favor Alcatel-Lucent (ALU) and Finisar (FNSR) as stocks to benefit from this theme.  Both are beneficiaries of the upward bias on capital spending while Alcatel-Lucent has the added benefit of a restructuring story and Finisar has the added benefits of relatively higher exposure to the optical upgrade in China and ramping deployments of “white box” switches by Web2.0 companies (e.g. Amazon) that utilize their optical sub-systems.  Keep in mind, both ALU and FNSR are very volatile stocks and can have extreme negative reactions to any negative earnings or other negative macro-economic and fundamental news.  In particular, Finisar reports earnings this week and Alcatel-Lucent has exposure to emerging markets.

Here are some key highlights of recent capital spending commentary from key operators in the US, China and Europe from 4Q13 earnings calls that took place in January and February:

China: After a delayed tendering process by China Mobile in 2013 for LTE equipment suppliers, a portion of China Mobile capital spending was delayed into 2014.  This deferral into 2014, combined with all the major operators ramping LTE spending in 2014 is likely to lead to an overall China capex growth of 15% in 2014 vs. prior expectations of about 10% growth.

US – In the US, AT&T, Verizon, T-Mobile, Comcast, Time Warner Cable and Charter all raised their respective 2014 capex plans vs. prior analyst expectations.  In addition, Google announced it is planning to expand its Google Fiber network to 34 additional cities in the future, which may add to the competitive pressure in residential broadband networks in future years.  Specific capex commentary from above mentioned US operators are as follows:

–       AT&T: Announced Project Agile that will result in capex being about $21B in 2014 vs. prior estimates of about $20B

–       Verizon: Guided 2014 capex to $16.5B-$17.0B vs. prior estimates of $16.0B-$16.5B.

–       Time Warner Cable: Guided 2014 capex to $3.7B-$3.8B vs. prior estimates of about $3.2B-$3.3B given new initiatives such as all digital conversion.

–       Comcast: Guided 2014 capex about $800M higher than 2013 given initiatives around digital set top boxes and WiFi routers.

–       Charter: Guided 2014 capex higher than expected by about $400M primarily due to all digital conversion resulting in 2014 capex of about $2.2B vs. prior estimates of about $1.8B.

Europe – In Europe, there continue to be early signs of a need for network operators to upgrade their networks after a period of cautious investment in the past few years.  The two most notable examples were Vodafone and Telefonica.  Vodafone announced Project Spring in 4Q13 that will result in capex of about £7.3B in 2014 vs. £6.2B in 2013.  Telefonica raised its expected capex/sales ratio for 2014 to 15.5-16% compared to 14.5% in 2013 to fund new network upgrade programs.

 

Juniper Has The “Edge” Over Cisco

I recently wrote an article on Seeking Alpha on my views on why Juniper is currently outpacing Cisco in the router market and how this is likely to continue through most of 2014.  Specifically, Cisco’s relatively older edge routing platforms vs. Juniper and the likelihood that Cisco has confused customers in the core routing market given two different product introductions in 2013 may be reasons for Cisco’s relative underperformance vs. Juniper.  One key data point to watch in 2014 for both Cisco and Juniper in the router market is AT&T’s Domain 2.0 process, which is likely to be completed by mid-year.    Given AT&T’s desire to maximize free cash flow given increasing investor concerns in this area (i.e. AT&T’s stock price fell the day after it reported earnings given a lower free cash flow outlook for 2014 vs. 2013), it is likely that product pricing will be a key factor in the Domain 2.0 vendor selection process, especially if Cisco continues to lose share to Juniper and Alcatel-Lucent in the router market in 2014 and it seeks to stop this trend by being more aggressive in the AT&T opportunity.

What To Do With ALU – Part 2

Over the past several months I have written often about my positive view on the communications equipment sector, particularly stocks with exposure to service provider capital spending. One of my favorite names as a play on this theme has been ALU.  I continue to remain favorable on stocks exposed to service provider capital speeding and in particular, ALU.  This week, the sector has had a strong performance, and I think the bias will likely continue to be positive in the coming months. The main drivers to the sector performance this week were: 

1. Positive earnings and outlook from Ciena on Tuesday as well as its positive commentary on the global 100G optical spending cycle

2. Positive mid-quarter bookings commentary from the CEO of Juniper at a Wall Street Investor conference on Tuesday as well as his positive commentary on the service provider router market

3. The sale of Vodafone’s stake in Verizon Wireless back to Verizon for $130 billion, of which about half will be in the form of cash.  Vodafone is likely to use part of this cash to increase capital spending in its other properties in Europe, which could form the beginning of a capital spending recovery in Europe.

Specific to ALU, there were two other perceived positives:

1. The sale of Nokia’s cell phone/device unit to Microsoft, which will add over $7 billion in cash to Nokia’s balance sheet.  Investors are hoping that once the device unit sale closes in 4Q13, the dramatic increase in cash at Nokia will enhance the probability of Nokia acquiring the wireless division from ALU.  Earlier in the year Nokia bought out Siemens’ portion of the NSNS JV and, together with other divestments in wireline infrastructure, has become focused primarily on wireless infrastructure and services.  A potential sale ALU’s wireless business to Nokia is something I have written about in the past as being a positive for ALU if it were to occur given ALU’s lack of scale in wireless.  Such a sale make ALU a more focussed company and more of a pure play on IP Routing and Optical where it has scale and technology leadership. 

2. The new CEO of ALU, Michel Combes, spoke at an investor conference and emphasized his number one priority is generating positive cash flow, in a great part through successful implementation of his “Shift” restructuring plan and generating at least $1 billion in asset sales.  I think Michel is more willing to consider a sale of the wireless unit (or part of it) than the prior CEO, but I think it is fair to say he will continue to focus on improving the wireless division’s margins and revenue growth rather than hope or depend on an asset sale as the main course of action.  Michel seems more focused on returning ALU to profitability and positive cash flow than the prior management team and less wedded to the prior strategy of keeping ALU being an end-to-end equipment supplier.  The fact that ALU hired an ex investment banker as its new CFO, also suggests “deal making” to enhance the cash position of the company may be a higher priority than in the past.

My sense is the positive spending commentary from Ciena and Juniper, the likelihood that European spending can only get better given a more cash rich Vodafone and the beginning of the 4G LTE upgrade cycle from China Mobile starting in 4Q13 will continue to provide a positive backdrop for technology companies exposed to service provider capital spending.   While Cisco’s surprisingly soft earnings report from a few weeks ago put a damper on the sector, most of Cisco’s issues were related to tough year ago comparisons in Japan, weak spending from certain emerging markets and China (which may partly be due to political issues) and a  declining set top box business.  These are not indicative in my view of the service provider spending catalysts I mentioned above.

I continue to be positive on ALU and remain long the stock but highlight that it remains a volatile stock, especially after the very strong performance of over 200% off the bottom in the past year. 

Disclosure: NT Advisors LLC may in the past, present or future solicit and/or generate consulting revenues from any company mentioned in this post.

Capex Continues Its Slow Drift Upwards

Following up on my most recent post on July 8th, I continue to see a slow but steady drifting upward of both telecom and networking capital spending.  An increasing competitive environment in the US wireless industry, the likely ramp of LTE spending in China in 2014 and the beginning signs of telecom spending bottoming in Europe should support service provider centric communications equipment stocks. In addition, while enterprise centric IT spending has not shown as vibrant of a recovery, recent results from distributors and other supply chain companies are starting to point to a recovery in enterprise networking spending.

Stocks that I have liked and continue to like in this current environment are Cisco, Alcatel-Lucent and JDSU.  While I continue to like all three of these names, I think the potential returns from current levels are not as significant as the respective returns over the past year. Specifically, I am looking for returns of 10%-20% over the next several months to year for both Cisco and JDSU, while ALU may have a bit more upside, yet with more risk as well.

Both Cisco and JDSU report earnings this week.  Wall Street is generally looking for Cisco to report results that are slightly better than consensus estimates, while there is a mixed view on JDSU going into its earnings.  The overwhelming consensus that Cisco will report a slightly better than expected quarter is a bit concerning as there seems to be little controversy going into results as compared to prior quarters. Thus, expectations are generally positive for Cisco, which leaves little room for any disappointment in their results. Even so, however, most signs seem to be positive for Cisco going into its results, including positive data points from its supply chain in 2Q results (e.g. distributors, contract manufacturers etc.), the continued strength in telecom capital spending in the routing area (as witnessed from both ALU and Juniper results) and a generally improving IT spending environment.  In addition, Cisco will be reporting its fourth fiscal report when it reports this week, which is generally a strong bookings quarter for Cisco.   This should support a solid year end backlog when results are reported.

With regard to JDSU, there is a mixed view going into their results, as most of its peers in the test and measurement business (e.g. Ixia, Spirent etc.) reported disappointing results.  On the other hand, optical component suppliers (e.g. Finisar, Alliance Fiber etc.) have generally reported (or pre-announced) positive earnings results.  Thus, there is more uncertainty around JDSU’s upcoming results and guidance.  My sense is if JDSU does offer either disappointing results and/or guidance, Wall Street will look at it as a buying opportunity as both these business segments are likely poised to improve in 2H13.

For my recent views on the security market post Cisco’s acquisition of Sourcefire, check out the following link.

Disclosures: I am currently long Alcatel-Lucent, Cisco and JDSU.  NT Advisors LLC may in the past, present or future solicit consulting business or have generated consulting business from any company mentioned in this post.

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.

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%+.