Share tip of the week: a turnaround play for the brave

So far 2007 has been a dreadful year for this telecoms equipment manufacturer. But it could be well set for future growth.

Tip of the week: Alcatel-Lucent (Euronext:ALU; NYSE:ALU), tipped as a BUY by Citibank

So far 2007 has been a dreadful year for Alcatel-Lucent (ALU). Its $11.6bn merger in December 2006 formed a global giant in the telecommunications equipment market. But after three profit warnings in nine months, the share price has fallen by 40%. The most recent problem was due to some large US wireless telecoms firms deciding to delay their capital spending until next year. From previous guidance of mid-single-digit growth, Alcatel-Lucent now expects 2007 revenues to be flat, or slightly higher than 2006. Worse still, underlying third-quarter earnings per share will be around breakeven because of a negative shift in the sales mix.

So why do I think Alcatel-Lucent is an interesting, if high-risk, turnaround play? Firstly, it was always going to be a challenge to combine two titans from different continents with diverse cultures. But integration is largely on track, with cost savings arriving as planned. Alcatel-Lucent reconfirmed last week that it would deliver e600m of savings this year, rising to e1.6bn by 2009 that's around 8% of operating margin.

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Secondly, while competition is intense, notably from Ericsson, Huawei, Cisco and Nokia, the telecoms-equipment industry should experience solid growth over the next five years, driven by huge increases in internet (IP) traffic. In a recent report, Cisco forecast that IP traffic will jump nearly fivefold from 2006 to 2011, driven by greater use of high-definition video and high-speed broad­- band. This jump will require telecoms operators, especially in emerging nations, to upgrade and expand their networks.

As the world's number-one player in key areas of this market, such as DSL (45% share), optical (24%) and US wireless (47%) telecoms equipment, which generate total sales of around e18bn a year), Alcatel-Lucent should benefit. Its research and development function, including the renowned Bell Labs, is top notch and owns about 25,000 active patents spanning virtually all communications technology. The board expects "strong sequential revenue growth" in the fourth quarter of 2007 , and is "confident" in the firm's prospects.

As for valuation: after successive earnings downgrades, the shares trade on a 2008 p/e of 16. On first sight, this looks fair, but I think the analysts are being too pessimistic. The brokers are assuming an underlying operating profit margin of only 6%-8%. But once the restructuring is completed, Alcatel-Lucent should be able to deliver margins of at least 10%, given its excellent technology and leading positions. For instance, Cisco, Ericsson and Nokia generate margins of 30%, 14% and 15% respectively. Assuming I'm correct, I would value Alcatel-Lucent shares on a 15 times 2009 p/e multiple, discounted back at 12%. That generates a fair value for the stock of around e7.60 or more than 20% above current levels.

Alcatel-Lucent is exposed to risks of price deflation in this competitive industry, together with ongoing restructuring issues. But at these down-trodden levels, I believe the shares are a high-risk buy and I'm not the only one who holds this view. Brandes Investment Partners, a respected value investor, owns a 10% stake, while Citibank has set a price target of e10 per share.

Recommendation: high-risk BUY at €6.20

Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments