These are still very early days, but if the second quarter is any sign, Alcatel-Lucent's (NYSE:ALU) latest restructuring efforts may bring this company (and stock) back into relevancy. There is still plenty than can go wrong, but the carrier spending environment is looking better by the month, and will likely put some significant tailwinds into Alcatel's sales. While I definitely missed out on the early jump in these shares, a pathway to $3.50 (or higher) for the shares is at least worth talking about today.

Solid Second Quarter Earnings, On A Relative Basis At Least
Alcatel-Lucent's second quarter results wouldn't have passed muster for a company like Cisco (Nasdaq:CSCO) or Huawei, but they weren't bad for a company that badly needs to re-establish its credibility with the Street.

Revenue rose 2% as reported (or 4% in constant currency) from last year, or 12% versus the first quarter. That was good for a 3% beat, as the company saw surprising strength in edge routing (leading to IP revenue growth above 20%) and better than expected results in LTE (leading wireless to 5% sequential growth. 

Margins likewise improved. Gross margin increased only slightly from last year, but improved 250bp sequentially. More importantly, gross margin beat the average estimate by more than 150bp. Adjusted operating income was positive (unlike the year-ago and quarter-ago results), and Alcatel's slim positive operating margin was almost 300bp higher than expected.

SEE: A Look At Corporate Profit Margins

A New Focus On Growth Products, Just As The Cycle Turns Positive Again
There have been a lot of false dawns with predictions of better telecom carrier spending, but it looks like conditions are finally, legitimately, getting better. Other equipment providers like Ciena (Nasdaq: CIEN) and Infinera (Nasdaq: INFN) have been seeing demand improving, as have Juniper (Nasdaq:JNPR) and Cisco. Results haven't been quite as strong as Ericsson (Nasdaq:ERIC) or Nokia Siemens, but then there too are some margin/mix improvement stories at work.

SEE: How To Pick The Best Telecom Stocks

As seen with Ciena and Infinera (and in recent announced wins), 100G is pretty strong for Alcatel-Lucent right now, and I would expect this market to get better over the next year or two. I still have my doubts about Alcatel's ability to compete, but I also don't believe that the company has to gain share to still benefit from this growing market. Edge routing, too, is looking quite a bit stronger for Alcatel as data traffic grows. As with 100G, I have my doubts that Alcatel-Lucent can grow share against its rivals (in this case, Cisco, Juniper, and Huawei), but once again Alcatel-Lucent doesn't have to “win” edge routing to still benefit from it.

We'll see what happens in wireless. Although Alcatel gets a lot of flack from bears (myself included in the past) for its share losses in LTE, a global share of around 15% to 17% is still good enough to allow the company to benefit from upcoming rollouts. The real question here may be margin, though, and Alcatel management could well face some difficult decisions with respect to how it bids on business.

On a somewhat related note, I thought it was rather interesting that Qualcomm (Nasdaq: QCOM) chose to partner with, and invest in, Alcatel for 3G/4G small cells. Qualcomm seems to be turning into something of an angel investor these days (at least between investments in struggling companies with good IP like Sharp and now Alcatel), and these small cell products won't roll right away, but it's hard not to see this move as something of an affirmation of Alcatel's IP and ability to endure.

The Bottom Line
I have long been very critical and skeptical towards Alcatel-Lucent, in large part because prior management line-ups couldn't execute their way out of a broom closet. And again, this is only one quarter and one where most of Alcatel-Lucent's comparables have sounded pretty positive on the market trends. So there's still a great deal of work left to do (and much to prove), but it's a good start.

I now expect Alcatel to return to positive free cash flow in 2015, and although liquidity is going to be tight for some time, improving financial performance over the next two years ought to create additional refinancing opportunities (though likely with higher base interest rates).

I'm still looking for long-term revenue growth in the neighborhood of 3% from Alcatel, well below Ciena and Infinera, but only a bit below Cisco. I'm more optimistic, though, that Alcatel can pull long-term free cash flow margins back into the mid-to-high single digits, though, and that leads to a discounted fair value (even with an elevated discount rate) of about $3.50. That's enough to make these shares worthy of consideration (something I wasn't sure I'd say again) even after this big run, and if the company continues to execute, those targets could head higher as the turnaround continues.
Disclosure – At the time of writing, the author had no positions in any stocks mentioned.

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