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In this screen, we have chosen to compare the price-to-earnings (P/E) ratios of companies in the telecom equipment and telecom services industries to identify stocks that are trading on the cheap. The P/E ratio is the most frequently used “value” metric. It is a fairly simple calculation that divides a stock’s price by the company’s earnings per share for a given 12-month period. By itself, the calculation provides minimal information, to properly use the P/E as a valuation tool, it must be compared to something.

The Telecom Services group includes several integrated telcos, which provide wireline, wireless, and other non-traditional services. Companies in this industry may have traditional wired operations, but most rely heavily (or solely) on wireless service for their revenues. Yields in this group are normally attractive.

Companies in the Telecommunications Equipment Industry produce technologies and services that are used to facilitate people's communications. Major products include cell phones, chipsets, wireless and landline infrastructure equipment, cable modems, and networking devices, such as routers and switches. The industry's customer base is highly diversified, including multi-national corporations, telephone companies, governments, universities, institutions, commercial businesses, and consumers. Stocks in this group normally have lower dividend yields than their Telecom Services brethren.

Of the 40 profitable stocks that came up on the list, we chose to consider those with P/E ratios in the bottom 25%. The results were as follows: (when signed in, subscribers can click on the company name to gain quick access to the full page Value Line report)

 

Company   Ticker   Industry    P/E Ratio 
             
Vonage Holdings VG   Telecom. Services 4.35 
             
Black Box BBOX   Telecom. Equipment  7.19 
             
Metro PCS PCS   Telecom. Services 8.52 
             
Alcatel-Lucent ADR  ALU   Telecom. Equipment 9.8 
             
UTStarcom Holdings UTSI   Telecom. Equipment 10.33 
             
j2 Global  JCOM   Telecom. Equipment 10.56 
             
Vodafone Group ADR VOD   Telecom. Services 11.13
             
Neutral Tandem IQNT   Telecom. Services 11.49
             
Cisco Systems CSCO   Telecom. Equipment 12.4 
             
Shenandoah Telecom SHEN   Telecom. Services 13.6 

 

Of these ten holdings, we chose to highlight one that stood out for its wide risk-adjusted recovery potential: Alcatel-Lucent (ALU).

Alcatel-Lucent

Alcatel-Lucent is a leading global telecom equipment vendor headquartered in Paris, France. Its products enable service providers, enterprises, and governments to transfer voice signals, data, and video across local and wide area networks. The company operates in three segments: Networks (44% of operating income), S3 (a.k.a. Software, Services, and Solutions, 38%), and Enterprise (18%). Most of ALU’s revenues come from telecommunications service providers. Its ten largest customers accounted for 43% of revenues in 2011 (among which Verizon (VZ - Free Verizon Stock Report) and AT&T (TFree AT&T Stock Report) represented 12% and 10%, respectively). According to industry research outfits Infonetics and Dell’Oro Group, Alcatel-Lucent had the following market positions in 2011:

• #1 in mobile backhaul with 25% market share
• #1 in CDMA with 37% market share
• #1 in broadband access with 37% DSL market share based on revenues
• #2 in LTE (behind Ericsson (ERIC)) with 24% market share
• #2 in service provider edge routers (behind Cisco (CSCO Free Cisco Stock Report)) with 23% market share
• #4 in W-CDMA Radio Access Networks with 10% market share based on revenues
• # 5 in GSM/GPRS/Edge Radio Access Networks with 7% market share based on revenues

Alcatel-Lucent has the fourth-lowest P/E ratio in the telecom space at 9.8 times forward earnings estimates. The stock price is down over 40% after reaching a 2012 high of $2.60 in late February. Speculation over potential weakness in the service provider capital expenditure market contributed to the stock price decline that led up to its first quarter earnings release on April 26th. This outlook turned out to be accurate. Investors were not pleased with the results and the shares plunged an additional 15% following the release.

Some of the weakness can be explained by Chinese regulators postponing some contract bidding activity until the second quarter. Elsewhere, European customers, faced with challenging economic conditions, have been choosing to maintain dividends and fortify defensive cash positions instead of investing in wireless infrastructure. Too, ALU’s Voice business has a lot of exposure to Southern Europe, and ought to continue being a drag in the coming quarters. As expected, CDMA infrastructure products are reaching the end of their lifecycles and ought to decline further in coming months. Nonetheless, extension of the IP product line, along with LTE base stations and very small cube-like service provider Wi-Fi access points dubbed lightradios, will likely offset this. In fact, the LTE business recently had its best quarter ever by generating three times last year’s revenues. This was not only thanks to more spending at AT&T and Verizon, but other global operators as well. Also of note, the Wireline business is seeing increased deployment of fiber optic infrastructure in countries like Mexico, Brazil, Australia, and New Zealand.

Still, the weak overall volumes (especially out of China), and the resulting inability to absorb fixed costs, contributed around two-thirds of a 400 basis point sequential gross margin decline in the March quarter. A mix shift away from lucrative Network Application Services and currency translation were also behind the steep fall in profitability. We view near-term volume issues as a temporary setback and think substantial improvement will come in the back half of 2012. Further, Alcatel plans to cut €1 billion from the fixed cost base on a year over year basis via headcount, IT, and real estate reductions. This ought to help remedy the margin situation. Diversification of the product line and expansion in emerging market should get the gross margin back on track.

The company is attempting to sell rights to its enviable and extensive intellectual property portfolio via a patent licensing syndicate called RPX Corp. (RPXC). That company has an extensive client base which it hopes to leverage and extract cash from its 29,000 patents. The initial response has been “very favorable”. Management expects negotiations to start this month. It will have a better understanding of the revenue opportunity when it releases June period earnings in July.

To be sure, there appears to be much debate over the company’s ability to meet principal payments on debt soon coming to maturity. We have confidence that Alcatel-Lucent’s current cash position will be sufficient to meet its upcoming debt payments.

Overall, we think investor sentiment is overly pessimistic. Alcatel ought to demonstrate progress in its margin expansion efforts in the current quarter and we think infrastructure demand outside of Europe will remain in decent shape. The very low-price to earnings ratio supports our opinion that these shares present a solid risk-and-reward scenario.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.