Two Companies with Massive Upside Regardless of Top-Line Growth

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In the last week, two companies, with almost the exact problems, both considerably undervalued, showed tremendous progress towards restructuring their business into a new era of success. Both of these companies have now seen their valuation increase, and I believe that both might be a buy!

Alcatel-Lucent Begins its Transformational State

In the last five years shares of Alcatel-Lucent (NYSE: ALU) had lost nearly 90% of its value prior to the last month. However, in four weeks Alcatel-Lucent has increased by 45% thanks to a significant shakeup in the structural plan of the company.

Alcatel’s rally began when rumors started to circulate about it exploring options to raise cash to boost its balance sheet; which included the sale of certain assets/segments and patents. It was first reported that the company was looking to raise $500 million, but when the company finally completed its financing it was just shy of $2 billion.

The money given to Alcatel-Lucent will allow them the opportunity to do what it should’ve done a long time ago; get rid of its unprofitable businesses. The company spans across 130 countries with nearly 30,000 patents valued at $6.5 billion, having total assets that exceed $23.5 billion. Therefore, with the financing, Alcatel now has the money to take time and divest some of these businesses, hoping to raise over $1.5 billion. The company will be able to focus on its core businesses, those that are profitable and growing such as with AT&T.

Rite Aid’s Sacrifices Pay Off

While Alcatel now has the money and leverage to begin its restructuring process, Rite Aid (NYSE: RAD) is now seeing the light at the end of its very long tunnel. On Thursday morning, the company reported its first quarterly profit in more than five years. This indicates a significant milestone in the turnaround of this company, as its focus on efficiency continues to benefit them.

The company reached this milestone after several quarters of relocating, remodeling, cutbacks, and with its overall efficiency plan. Much like Alcatel this continues to be a company of great debt and balance sheet woes. However, its $60.5 million in profit is a huge step in the right direction, and the company’s decision to increase EPS guidance for 2013 is an indication that such improvements will continue.

Alcatel and Rite Aid’s Common Bond

There are two similarities between both Alcatel-Lucent and Rite Aid: Both companies are losing revenue and both companies have massive upside if their efficiency plans are effective. First, despite Rite Aid’s 16% gain on Thursday, the company did post a same store sales decrease of 1.5% with a presence of more generic prescriptions as the culprit. The company is now expecting full-year 2013 sales between $25.15 and $25.30 billion, which is a very slight loss compared to the last 12 months.

Alcatel offered its creditors a glimpse into its financials and into its guidance for the next year. The company is expecting to post significant losses in revenue, guiding for about $16 billion with operating margins between 6-9%. However, much of Alcatel Lucent’s plan is to cut unnecessary revenue by selling the parts of its business that don’t return a profit.

To some the fact that both Alcatel and Rite Aid are losing money might sound like a negative, however due to the market value of both companies, revenue is almost irrelevant. Because in regards to these two companies, investors do not care about revenue. In fact, these two companies could probably lose half their revenue, but with strong margins could have a market capitalization twice their current cap. To better explain take a look at how these two companies measure against competitors in terms of operational size/valuation.

 

Rite Aid  

CVS Caremark (NYSE: CVS)

Market Cap (billions)

$1.09

$61.20

Revenue (billions)

$26.16

$120.08

Operating Margin

1.01%

5.73%

CVS has just over 4.5 times more revenue than Rite Aid, but is valued at more than 61 times Rite Aid’s market cap. This shows the level of importance that the market places on margins. If Rite Aid can continue to become more efficient and maximize profits then it can trade considerably higher. Even if the company could achieve a profit margin of 1% it would have income of $260 million. Seeing as how CVS trades at 16.66 times earnings I believe that with a 1% profit margin Rite Aid could reach a market cap of $4 billion in the next two years, assuming continued margin growth.

 

Alcatel-Lucent

Juniper (NYSE: JNPR)

Market Cap (billions)

$3.24

$10.50

Revenue (billions)

$18.77

$4.35

Operating Margin

0.49%

9.51%

The exact same scenario that’s true for Rite Aid is also true for Alcatel and how it relates to Juniper. In fact, this comparison shows you first hand the emphasis placed on margin strength and profits. Alcatel is a much larger company than Juniper, but is a third of its valuation. Therefore, if Alcatel could reach a profit margin of just 3% (compared to Juniper’s 4.30%) then it could very well see a P/E multiple of 25-30 (Juniper’s 57). Even if Alcatel sells off all of its bad assets and becomes a company with revenue of just $15 billion (keeping all of its growing segments) it could still see a market cap over $13 billion with less revenue.

Conclusion

The bottom line is that a restructuring plan was desperately needed for both companies and that the market could care less about either’s top line performance. At this point, the market wants efficiency and profits to reward either with a larger market capitalization. And both companies are now on the right path to achieve this feat. 


BrianNichols is long ALU, RAD. The Motley Fool has no positions in the stocks mentioned above. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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