The Reasons for Alcatel's 'Shocking' Miss

The newly merged Alcatel-Lucent missed revenue targets by a wide margin, due to weaknesses in wireless and beyond

by Carol Matlack

The party's over. Less than two months after global telecom equipment giants Alcatel and Lucent celebrated their merger with a gala Paris reception, new Chief Executive Patricia Russo has rattled the markets with a profit warning.

On Jan. 23, Alcatel-Lucent (ALU) acknowledged that fourth-quarter sales fell 16%, wiping out quarterly profits and pushing full-year revenues slightly below the $24 billion posted in 2005. "The last quarter of the year proved challenging from a market perspective, driven by a shift in spending from some of our large North American customers and heightened competition in the global wireless market," Russo said in a prepared statement. Russo, an American, is Lucent's former boss.

The surprise announcement sent shares down as much as 12%—and no wonder. The Paris-based company seems to be losing ground on almost every front. Its U.S. wireless business, inherited from Lucent, "cratered in the December quarter," Merrill Lynch (MER) analysts said in a research note. They called the fourth-quarter numbers "shocking" and downgraded the company's shares to "neutral."

'Structural Issues'

An even bigger jolt was the weakness of Alcatel-Lucent's wireless business outside the U.S. Although the company provided no details, analysts say rivals such as Ericsson (ERIC) and Huawei Technologies are relentlessly building market share in supplying network equipment to mobile operators. Even the broadband and fiber-optics business, traditionally an Alcatel strong suit, has weakened.

"There are big structural issues that Pat Russo faces, apart from achieving the synergies" promised from the companies' $16.9 billion merger, says Rémi Thomas, an analyst at Paris-based brokerage Cheuvreux (see BusinessWeek.com, 11/30/06, "Alcatel-Lucent CEO's Tricky Trip to Paris").

Alcatel-Lucent says a key obstacle last year was that many phone companies and wireless operators hesitated to place big orders while the complex Franco-American merger was still in the works. "We feel confident that Alcatel-Lucent can resume growth in full-year 2007," Russo said.

Looking for Savings

But analysts say the company should have foreseen those problems and warned investors sooner. "A €500 million miss on revenues? It bothers me that they didn't see it coming," says Richard Windsor, a London-based analyst with Nomura Securities. "Visibility remains very poor."

The weak 2006 numbers increase pressure on management to deliver the $1.8 billion in post-merger cost savings it has promised over the next three years, including a 10% reduction in its combined 88,000-person workforce. Indeed, Alcatel-Lucent said on Jan. 23 that because of the weak 2006 performance it would take unspecified "additional actions to further reduce its cost structure."

The picture isn't all grim. Alcatel-Lucent has a comfortable $7 billion cash balance, providing "headroom for restorative measures," said analyst Leandro De Torres Zabala of Standard & Poor's in a research note. S&P, which like BusinessWeek is a unit of The McGraw-Hill Cos. (MHP), maintained its debt rating on the company after a downgrade in early December. But 2007 is clearly shaping up as a very tough year for this newly formed company.

De Torres Zabala said in an interview that Lucent must continue to cut costs, primarily by eliminating jobs in overlapping parts of the former Lucent and Alcatel businesses. He said the company must also capitalize on the increasing adoption of high-speed wireless networks, known in the industry as "third-generation" networks. Wireless companies such as Verizon Wireless (VZ), Sprint Nextel (S), and Cingular (T) have been building out these networks in the U.S., while other carriers have been building them in Asia and Europe.

Hopes for Alcatel Lucent were high when the merger was announced. (see BusinessWeek.com, 4/3/06, "Alcatel and Lucent: A Global Logic") But in 2007 it’s clear that the newly formed company is off to a very rocky start.

Matlack is BusinessWeek's Paris bureau chief.