Cutting Costs Should Not Be Part of This Company’s Plan!

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

Telecom equipment company Alcatel-Lucent (NYSE: ALU) is on pace to post its first year of gains since 2009. In 2013, the stock has rallied 35% -- but during the last seven months the stock is higher by 87%.

These large gains are not due to any fundamental improvements – rather a plan on behalf of the company to monetize its industry-leading IP portfolio and divest the problem areas of its business.

Back in December, Alcatel secured $2.1 billion to undergo this process, thus leaving many bullish of its future. However, a bearish article in the Wall Street Journal by Renee Schultes pushed shares lower by 1.5% on Tuesday, as she has serious doubts of the company’s direction.

Could put off drastic surgery?

In the article “Alcatel-Lucent Could Put Off Drastic Surgery,” Schultes writes that the new CEO, Michael Combs, might very well place a greater emphasis on cost-cutting versus asset sales.

Schultes does not source any reports in her piece, but rather presents it as a “hunch.” If correct, this would contradict the company’s public plan and would be bad news for the stock – due to the $2.1 billion in debt financing being raised to unload assets.

Schultes might be right

As an Alcatel long, I hate to admit it, but Schultes may be right. Schultes is simply stating what most investors have thought during the last few months.

Michael Combs has been the CEO at Alcatel for approximately four months. Therefore, the debt financing and “plan” to divest was announced by the prior CEO. At the time, there were a lot of reports that Alcatel’s old-school board was not thrilled about a leaner and meaner Alcatel. Therefore, it is possible that Combs will have a different vision, and it could be cost-cutting.

Combs will outline a business strategy on Wednesday, and I must say, I am nervous about what we might learn. Alcatel-Lucent has a long and storied history of cutting costs. The company currently employees more than 70,000 people, which is about half of its employment compared to 2008.

While laying off employees has “cut costs,” the stock is lower by 71% during this period, showing that “cutting costs” is no longer effective. Alcatel-Lucent needs to take drastic measures to create shareholder value.

It’s time to quit playing around

With a market cap of just $4.25 billion, not many people realize the size of Alcatel-Lucent. This is a company with sales of $18.73 billion over the last 12 months; meaning it trades with a price/sales of just 0.23.

Alcatel’s most significant competition includes Cisco (NASDAQ: CSCO) and Ericsson (NASDAQ: ERIC). Cisco has revenue of $47.88 billion and Ericsson has $34.35 billion over the last 12 month. Hence, Cisco and Ericsson are 2.55 and 1.83 times larger than Alcatel in terms of business size. Yet, Cisco has a market cap of $132 billion and Ericsson is worth almost $40 billion.

The market is deeply discounting the size of Alcatel-Lucent. Cisco, a company that is just 2.55 times larger, is worth 31 times more than Alcatel; and Ericcson is worth nearly 10 times more than Alcatel. These companies operate in the same industries, yet are different in operating efficiency.

Company

Operating Margin

Price/Sales Ratio

Alcatel-Lucent

0.37%

0.23

Cisco

17.80%

2.76

Ericsson

7.98%

1.12

As you can see, the higher market capitalization relative to sales is awarded to the company with the higher margins. Therefore, sales are really meaningless in this industry. For further proof, Juniper Networks (another competitor) has a market cap that is more than double of Alcatel, yet has just 25% as much revenue. The moral to this story: Alcatel needs to quit fooling itself, and quit trying to maintain its size, because margins are what investors want to see.

Final thoughts

If you look at the chart above, you might see weakness for Alcatel, but I see room for improvements. Alcatel operates in numerous industries, across dozens of countries, and some of these operations create very nice margins.

The company has a very good presence in North America, recently won a contract in China, and is even expanding networks in Europe. However, there is no reason for the company to keep segments such as its submarine optical cable unit. This one unit in particular has an estimated worth of $1.1 billion, and does nothing but drag Alcatel’s margins lower. A sale of this level could drastically change the landscape for this company.

On Wednesday, investors need to hear that Alcatel is serious about its divesting program, and that it is ready to sell assets. This is a company whose sum of parts are worth about 5.5 times its market capitalization ($18.73 billion revenue times the telecom industry price/sales ratio 1.25).

The company needs to unload these assets and focus on the assets that return high margins. Then, with money raised from selling assets, it can pay off debt and become more efficient. If the company maintains this course, the upside for the stock could be unprecedented, definitely the greatest in the telecom equipment industry due to its valuation. But if not, then expect most of Alcatel’s seven month gains to be returned to the market, as these gains were in response to the possibility of “change.”


Brian Nichols owns shares of ALU. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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