"Adieu" to Russo and Tchuruk, hello to the next phase

Financial analysts were expecting Alcatel-Lucent to post a loss of around $135 million for 2Q08, but the vendor reported a $1.1 billion loss, mainly due to a goodwill impairment charge of $810 million following the steep drop in North American CDMA revenues.

After reporting losses for the sixth quarter in a row and a 60% decline in the share price since November 2006, the company finally acknowledged that it was time, as CEO Pat Russo said, for new leadership with an "independent and fresh perspective". Despite her claim that the merger process is now behind the company and it is on track with its objectives, the new CEO's task will be challenging.

Russo mentioned in the conference call Q&A period that of the company's 17 businesses (P&Ls) "14 are at or better than plan." There isn't a one-to-one correspondence with its P&Ls, but the company noted on the plus side that its terrestrial and submarine optical, services, applications, NGN/IMS, enterprise, data networking, IP telephony, edge routing and carrier Ethernet switching, Wimax, GSM, W-CDMA, IPTV, and FTTx businesses were doing well.

xDSL port shipments dropped 20% year over year, but 2Q07 was a huge quarter for the company, with 9.6 million ports shipped, and shipments were up 16% sequentially. Even the company's convergence business posted revenue growth "for the first time since the merger."

[x-head] Emerging markets

Through 1Q08 (our 2Q08 quarterly research is incomplete as many vendors have yet to report), Alcatel-Lucent maintained a strong number one position in xDSL, GPON, and optical networking (terrestrial plus undersea) and was fighting with Juniper as Cisco's closest rival in the carrier switching/routing market. With about half of its business in US dollars or dollar-denominated currencies, the dollar's devaluation -- 13% between 1H07 and 1H08, according to the company -- hurt. But the locus of its problem is in its wireless business.

Alcatel-Lucent's wireless business has been badly impacted by a faster-than-expected decline in CDMA, particularly in the US where its most significant CDMA customers are. Even though CDMA business opportunities still exist in emerging countries, the company noted that these are not enough to compensate for its exposure in North America.

In emerging markets, the CDMA competition with the Chinese vendors (ZTE in particular) is intense. As a consequence, Alcatel-Lucent decided to reflect the uncertainty regarding CDMA spending in North America by making more cautious assumptions for CDMA sales over the next five years, which led to the non-cash impairment charge of $810 million mentioned earlier.

More globally, Alcatel-Lucent is riding multiple horses in the wireless infrastructure segment. On one hand, this can be perceived as a competitive advantage, enabling the company to serve more market opportunities and protecting it against difficulties that may arise in a particular market.

At the same time, however, supporting multiple wireless standards requires more resources to be dedicated to R&D, product development, marketing, sales, and support. Today, Alcatel-Lucent is the only Western vendor to offer or develop products for all wireless technologies (GSM, UMTS/HSPA, LTE, CDMA2000, Wimax). The only others doing so are Chinese companies ZTE and Huawei, but their cost structure and access to capital are more favorable than Alcatel-Lucent's.

In telecoms -- a very challenging market due to significant price competition and buyer power -- scale is vital.

 

Without significant scale, profitability suffers. In that context, mergers are presented as the best means to create scale. However, simply adding more product lines does not create scale -- the vendor must also go through a painful product rationalization process before reaping scale benefits.

For example, in its UMTS business, Alcatel-Lucent had three different product lines to rationalize after the purchase of Nortel's UMTS business. As a first step, Alcatel-Lucent kept selling Lucent's solutions to AT&T while replacing Alcatel's Evolium UMTS products in favor of Nortel's UMTS radio solutions elsewhere. The next step is to move to a single, common platform before the end of 2008.

Product rationalization has an obvious R&D cost -- the need to build a common platform -- but it also has a marketing cost as the vendor needs to keep customers of discontinued platforms on board. In addition, competitors will try to benefit from any discontinuities and grab market share. This is what Ericsson and Huawei did last year at the expense of both Alcatel-Lucent and Nokia Siemens Networks.

[x-head] Strong W-CDMA sales

The good news is that much of Alcatel-Lucent's rationalization process is now behind it.

The company announced strong W-CDMA sales at AT&T, SKT, KTF, and Orange during 2Q08. Its W-CDMA revenues grew by 60% versus the year-ago quarter. In addition, it claimed that it is in line with its objective to halve operating losses in W-CDMA (and NGN/IMS) for fiscal 2008. The company also said that it now sees stronger demand than expected for UMTS and GSM, especially from Asia and China.

Even in the early post-merger stage, Alcatel-Lucent maintained strong GSM sales, especially in emerging countries, thanks to the new GSM product line (TWIN TRX and ATCA BSC) introduced in early 2007. It has a strong GSM position in emerging markets and should be able to leverage this in the future for new GSM expansion plans and UMTS introductions.

Alcatel-Lucent went "live" in December 2006, less than two years ago. The company has accomplished a lot in a short time, but it needs to do more. A change in the upper management signals that the company is ready to shed its Alcatel plus Lucent past and become something new.

The company continues to execute well in many areas. With additional product line rationalization and additional focus on services and growing infrastructure markets, we are optimistic that better days are yet to come.

Dana Cooperson and Julien Grivolas, Analysts at Ovum