Is Alcatel Back?

Margins are up, and operations could be profitable in 2003

As recently as early November, French communications equipment giant Alcatel (ALA ) looked to be one of the likeliest survivors of the global telecom meltdown. Then phone companies around the world began previewing their 2003 capital-spending plans, and it became increasingly clear that any hoped-for pickup next year wasn't going to happen. There's still too much capacity, too little demand, and not enough capital to turn the telecom sector positive before 2004--at the earliest. "We're still in the Valley of Death," says John Ryan, a principle at research consultancy RHK Inc. in South San Francisco, who predicts that communications equipment sales will contract an additional 6% in 2003, after falling 26% this year and 5% in 2001.

The grim news raised new concerns about Paris-based Alcatel. Despite having slashed 47,000 of 130,000 jobs since 2000, whacking operating expenses by 25% in the past 12 months, and more than halving net debt this year, to $1 billion, the crown jewel of French high-tech still faces serious risks--and might even run low on cash in 2005. That possibility prompted Merrill Lynch & Co. and Deutsche Bank to lower their Alcatel estimates in November and advise clients to sell the stock. French business daily La Tribune chimed in with a story on Nov. 19, headlined "Will Alcatel survive the telecom crisis?" The next day, Moody's Investor Services lowered Alcatel's credit rating to three levels below junk, matching an earlier downgrade by Standard & Poor's.

Pretty bleak, but a curious thing happened on the way to the funeral. Investors ignored the experts and bought Alcatel shares. Since Nov. 19, its stock has jumped 15%, to $5.62, after more than doubling from a low of $2.05 on Sept. 24. That still leaves Alcatel off 74% for the year, but it's in a better position than rival Nortel Networks Corp. (NT ), whose stock is down 75%, and wireless giant Ericsson (ERICY ), off 79%. Investors are impressed that the French company has become the industry's top player during the worst downturn in telecom history. "Alcatel has simply weathered the downturn better than others," says analyst Per Lindberg of brokerage Dresdner Kleinwort Wasserstein in London.

Look no further than sales results. No doubt, Alcatel has been hit. Revenues totaled $12 billion for the first nine months of 2002, down 35% from a year earlier. But Nortel and Lucent Technologies (LU ) fared even worse: Their sales fell 43% and 48%, respectively. "Two years ago, many of our peers were bigger than we were, but now we're bigger," says Alcatel Chairman and Chief Executive Serge Tchuruk. He credits Alcatel's greater global reach and more diverse product line for cushioning the downturn's impact.

The French company also took an axe to itself with surprising fervor, outpacing rivals in cost-cutting and cash management. In the third quarter, Alcatel boosted gross margins by nearly four percentage points, to 27.5%, and spun off $200 million more in operating cash flow than analysts had expected. Performance like that prompts even analysts negative on Alcatel to concede that it's likely to be the first among its peers to return to operating profitability, sometime in 2003.

There's a big "if," however--and that's what worries credit agencies. Alcatel has been so successful at selling off assets, reducing inventory, and trimming expenses that it doesn't have much wiggle room left. As long as sales don't decline more than 25% next year and Alcatel wrings out planned cost reductions, Moody's figures, it ought to be in the clear. But if the market worsens, Alcatel's liquidity could become dangerously low in 2005.

Tchuruk dismisses such worries. Noting that only two-thirds of Alcatel's revenue comes from telecom--the rest is satellites, industrial components, and other businesses--he says telecom spending would have to fall 40% next year to drag down Alcatel. To be on the safe side, though, he has ordered managers to chop 25% more spending, including less R&D and cutting 23,000 more staff by the end of 2003. "We are lowering our breakeven point to way below what we expect [from the market]," says Tchuruk, who is sticking to his promise to make Alcatel profitable next year.

The CEO also aspires to more than just black ink on the bottom line. He's itching to restart top-line growth and thinks Alcatel is well placed to do that. The key: remaining a soup-to-nuts supplier while exploiting areas such as broadband Internet access, where Alcatel is a clear No. 1 worldwide. Tchuruk is still pumping money into digital subscriber line (DSL) technology, and funding fiber optics research & development, despite the current market glut in Europe and North America. According to telecom consultancy Infonetics Research of San Jose, Calif., Alcatel's global share of the $2.2 billion annual DSL business topped 40% last quarter, up from 33% the quarter before, a gaping lead over the 14% notched by No. 2 UTStarcom Inc. of Alameda, Calif. Better yet, amidst general weakness, the DSL market is on track to grow 11% next year, Infonetics predicts. Alcatel also is faring well in China. Researcher RHK figures Alcatel increased its share of the growing Asian fiber-optic market in the first half of the year to 12%, from 4%.

If the downturn persists, though, Tchuruk may yet have to lop off a few limbs. Alcatel has the lowest revenues per employee among the top eight communications-equipment makers, according to Technology Business Research Inc. of Hampton, N.H. Its operating margins are well below those of Cisco Systems (CSCO ), Nokia (NOK ), Motorola (MOT ), and Siemens (SI ). Analysts such as Merrill Lynch's Adnaan Ahmad say Alcatel has to become far leaner and more efficient if it is ever to reach the profit growth expectations already priced into its stock.

Is Tchuruk the person to do that--or could he be the next French CEO casualty? Sources say he's unlikely to be sacked like Vivendi Universal's (V ) Jean-Marie Messier or France Télécom's Michel Bon. He is well connected in business circles and sits on the boards of Société Générale and oil company TotalFinaElf, among others. Investors don't blame him for Alcatel's predicament. He didn't, for instance, load it with debt from risky acquisitions during the boom, and his stewardship during the downturn is widely admired.

Tchuruk, 64, won't stick around forever: He has taken steps toward retirement within five years by bringing in a new president and heir apparent, Philippe Germond, until now the CEO of No. 2 French telecom company Cegetel. Germond joins Alcatel on Jan. 1. His apprenticeship couldn't come at a tougher time. But if Tchuruk can guide Alcatel across the Valley of Death, Germond might end up taking over the world's largest telecom gear maker just when the sector comes back to life.

By Andy Reinhardt in Paris

Before it's here, it's on the Bloomberg Terminal.