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.

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.

 

 

 

 

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….