Alcatel-Lucent: Will a Return to Profitability Keep the Stock Moving Higher?

Alcatel-Lucent has no revenue growth, but does its return to profitability make it a better investment than peers Cisco, Ericsson, and Nokia?

Feb 10, 2014 at 9:00PM

Alcatel-Lucent (NYSE:ALU) delivered its first quarterly profit in two years earlier this month, and soared considerably higher. Yet, with revenue growth being non-existent, does a return to profit make Alcatel-Lucent a better investment opportunity than mobile infrastructure and communications & networking peers Ericsson (NASDAQ:ERIC), Cisco (NASDAQ:CSCO), and Nokia (NYSE:NOK)?

Alcatel-Lucent is shifting its focus
In the last year shares of Alcatel-Lucent have traded higher by 170%, including more than 6% in the final two sessions of last week.

The driver of recent gains were the company's quarterly report, where the impact of its "Shift" plan has become fundamentally evident. The goal of Alcatel's Shift plan is simple: Divest assets that are unprofitable to the overall business, focus on the fastest growing and most profitable segments, and to maximize employees to earn consistent profits.

Alcatel-Lucent has already divested and sold smaller assets, but announced that China Huaxin has made a $362 million bid to acquire an 85% stake in its telephone unit. As a result, Alcatel removes debt, increases its cash position, and sees a boost to its margin.

Consequently, overall year-over-year revenue growth is not currently part of the Alcatel story. In fact, overall revenue declined 4% compared to last year, totaling $5.31 billion in its fourth quarter. Still, the company has already begun to see an effect of its Shift plan.

Specifically, adjusted operating income rose 167% year over year to $414 million, and the company's gross margin increased from 30.4% to 34.3%. The reason for these incredible improvements is because the company has less junk that's weighing down the strengths of its business.

Gaining ground on its peers
Alcatel-Lucent had strengths throughout its quarterly report, but what might be most impressive is the company's 5% increase in operating margin to 7.8%, which then translates to a net income of $181 million. Notably, the company stated on its conference call that this margin improvement is sustainable.

So, with operating margins of 7.8%, Alcatel-Lucent isn't yet as efficient as its peers, but it's gaining ground; this includes Ericsson, Nokia, and juggernaut Cisco.

Ericsson, Cisco, and Nokia all operate in the same industry as Alcatel-Lucent. Ericsson and Cisco's operating margin is 10.3% and 24%, respectively. In regards to Cisco, nearly 80% of its revenue comes from products rather than services, which is why its margins are so much higher than its peers.

Ericsson is most often compared to Alcatel-Lucent, and following Nokia's sell of its handset unit, it now directly competes with Alcatel-Lucent as well. With that said, Nokia's 9% operating margin in the last year is not a direct reflection of how it will perform from this point forward. Instead, the company's operating margin of 11.2% in its last quarter might be a better indicator of what to expect.

Therefore, despite Alcatel's improvement, it is still carrying the smallest operating margins. As a result, and given its restructuring, one might imply that Alcatel-Lucent has the most to gain in operating improvements over the next few years.

What's the best metric for finding value?
Now that we know Alcatel-Lucent has the most to gain, but is now operating on a level that can be compared more closely to its peers, it's time to figure a way to determine upside or the best value opportunity in this space.

In assessing these particular companies, profits or P/E ratios are meaningless, as all operate at different levels of efficiency. While Cisco is a prime performer, Alcatel is in the middle of a restructuring process. Moreover, Nokia has been completely transformed, and Ericsson is making large investments now to grow later.

Therefore, if we assume peak margins to be around 20% in this space, and understand the many differences that separate these companies, assessing sales compared to valuations might indicate which company has the most to gain from continued improvements.

Company

2014 Revenue Estimates

Price/2014 Revenue

Alcatel-Lucent

$20.43 billion 

0.50

Nokia

$17.97 billion 

1.58

Ericsson

$36 billion 

1.1

Cisco

$48.2 billion 

2.5

 The chart above shows the analyst estimates – which are not always correct – for full-year revenue in 2014. Then, it shows how each company is priced compared to future sales. If margins improve, the company priced the cheapest relative to sales should have the most upside.

Hence, Alcatel-Lucent looks like the clear winner, especially given its new-found profitability, and given the fact that such improvements are here to stay. In fact, using the chart above, Alcatel could double from this point and would still be the cheapest stock.

Other that Alcatel, Nokia is going through a transition, and apparently, investors are already taking big bets on this new chapter in the company's life.

Cisco is guiding for growth of 3% to 6% annually over the next three to five years, which is below prior guidance of 5% to 7% annual growth. Ericsson is growing at nearly the same rate, yet is significantly cheaper. Thus, Ericsson looks better, but still, Alcatel-Lucent is the best value.

Final thoughts
Despite an incredible year of stock gains, Alcatel-Lucent is still the cheapest among its peers, which means it likely still presents the greatest upside.

This goes to show that stock performance doesn't always indicate future performance or current value, a great lesson for all to learn. With that said, Alcatel must still execute properly, but if the company can really maintain margins around 7%, then it does appear that brighter days are ahead for this company.

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Brian Nichols owns Alcatel-Lucent. The Motley Fool recommends Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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