Alcatel-Lucent (NYSE:ALU) has had a long, difficult run. Created through the combination of two once well-respected, but struggling, telecom equipment vendors, Alcatel-Lucent has itself struggled to drive efficiencies from the merger. Making matters worse, the company has had to cope with a challenging capital equipment market while dealing with the rise of Chinese rivals Huawei and ZTE.

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Now, though, it looks as though the company may be making real progress towards becoming a more efficient operator and translating its good market share into better shareholder returns.

A Good Start to the Year
Alcatel-Lucent posted a pretty solid first quarter. While revenue did fall 23% on a sequential basis, revenue did grow about 15% on a year-on-year basis. Like Ericsson (Nasdaq:ERIC), Alcatel-Lucent saw a relative benefit from its wireless business, while the optics business was less impressive. IP performance depends on the context - a 31% sequential drop was pretty weak, but the 28% year-over-year growth was solid.

Alcatel-Lucent is also making good progress on its profitability. Gross margin stayed flat on a sequential basis (impressive given the revenue drop), while increasing about 360 basis points from the year-ago level. Operating performance was more mixed, as the company did see a sequential drop, though it managed to maintain an operating profit for the quarter.

Wireless a Near-Term Key
Alcatel-Lucent is seeing better business in its wireless segment, and the company clearly needs this to continue. While Huawei and ZTE are building share in Asia, Alcatel-Lucent has nevertheless managed to get contracts from the three major Chinese service providers (China Mobile (NYSE:CHL), China Telecom (NYSE:CHA) and China Unicom (NYSE:CHU)). These are not small deals either, and ALU's partnership with China Mobile for a next-generation network could pay large dividends in the years to come.

In the meantime, Verizon (NYSE:VZ) and AT&T (NYSE:T) continue to spend large amounts of money to upgrade and expand their networks. While a major deal with Verizon for LTE equipment should bring in revenue, Alcatel-Lucent will need to prove it can drive better margins from this business.

Other Businesses Show Promise
Although this quarter wouldn't prove this, the IP and optics businesses are looking better as well. The company's newest routing platform is competitive with Cisco (Nasdaq:CSCO) and Juniper (Nasdaq:JNPR) and may be better in many respects. With optics, the necessity of carriers to upgrade long-haul networks should help the company build some momentum here.

The Bottom Line
With the recovery in communications spending, the recovery in the stocks of Alcatel-Lucent and Ciena (Nasdaq:CIEN) have been nearly identical since early 2009 and well ahead of Ericsson. What's interesting, though, is that Alcatel-Lucent is still quite a laggard on a longer-term comparison - five-year owners of Ciena have just about broken even, while ALU holders are still deep in the red.

The arms race in wireless would suggest that Alcatel-Lucent can go quite a ways further from here. The real trick is whether or not the company can drive better margins. Middling margins mean middling cash flow and a fair value target that is not so exciting. A return to the better margins of long-past, though, would make for a dramatically different outlook and a potentially very interesting stock today. (For related reading, also take a look at How To Pick The Best Telecom Stocks.)

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