Alcatel-Lucent (ALU): Acquisition target?

by Paul McWilliams, editor Next Inning

A subscriber recently asked us if Alcatel-Lucent (ALU) is a viable buyout candidate. Here's our assessment of the stock's outlook and its buyout potential.

Central to ALU's challenge is its high fixed cost structure. Current management has addressed that more effectively than what we saw previously, but there is still progress that needs to be made before ALU can realize the cost flexibility it needs to optimize its model.

Beyond the complications these high fixed costs present, ALU was hit last year by delays in capital spending on next generation wireless networks.

At the beginning of 2011 it was widely believed we would see capital spending on these networks begin to build meaningful traction during the second half of the year. That didn't happen.

While all of the companies that were betting on this traction suffered, companies with high fixed cost structures suffered the most.

In short, companies that operate with a high fixed cost business model, particularly companies that operate in cyclical end markets, get hit the hardest when there is a cyclical downturn or a push out of an expected spending pattern.

The reason is simple; companies with high fixed costs models have inherently low cost flexibility and are, therefore, very sensitive to fluctuations in revenue.

Prior to the management change at ALU, and its subsequent focus on adjusting the structure of its operating model to reduce fixed costs, it was in a prime position for a takeover by a private equity. However, its stock price was higher then, so that part of the equation wasn't there.

Today we see ALU addressing the right priorities, but the stock price is far lower. This opens an opportunity for private equity that wasn't there before.

1) The price is low enough today that a private equity group could offer a substantial premium that would likely be acceptable by the board and the shareholders.

2) ALU is already taking the right steps to improve its operating model.

3) ALU is positioned well to participate in the build out of next generation networks.

I think given the prospect that ALU will report revenue this calendar year above $20B, the company could bring $4 per share in a buy out pretty easily and, possibly, something in the range of $5 to $6.

However, as an investor I would not buy shares of ALU based on the thought it will become an acquisition candidate.

That said, I think if ALU executes as I expect it will, and the demand for next generation wireless networks builds traction as most observers are forecasting it will this year, I believe ALU will merit a price of $4 to $6 on its own.

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