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.