Share tip of the week: well-placed telecoms giant

An explosion in data traffic is causing a stir in the telecoms sector. Video-on-demand is putting strain on broadband infrastructure and, given the popularity of smartphones and netbooks, mobile surfing is compounding the congestion. In many cases, bandwidth owners such as BT, AT&T and Verizon have no option but to open their purses and spend some serious bucks. And that's sweet music to the ears of Alcatel-Lucent, one of the world's largest telecoms-equipment makers.

To date the merger of the two businesses in 2006 hasn't delivered a single euro in profits hence the prolonged tailspin in the share price. The idea was to create a powerhouse that could compete with Sweden's Ericsson, the industry leader, and Huawei Technologies, a fast-growing Chinese rival. But due to political in-fighting and the recession, cost savings from the deal have had to be reinvested in lower prices.

Now, though, CEO Ben Verwaayen is in the midst of implementing a tough-nosed turnaround plan. Substantial overheads have already been stripped out. The aim is to move back into the black later this year on turnover of e15.2bn and then to deliver earnings before interest, tax and amortisation (Ebita) margins of 5% to 9% in 2011.

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Alcatel-Lucent (Euronext: ALU), rated a BUY by Soleil Securities

What's more, Verwaayen seems to be assuming the market will expand by only 0% to 5% in 2010, in contrast to strong underlying demand. So I think Alcatel-Lucent will outperform. After all, one of its rivals, Nortel Networks, is in disarray having been sold-off piecemeal due to bankruptcy. And according to Bloomberg, the Indian government is stopping Chinese manufacturers selling networking gear to domestic carriers after a spate of global cyber attacks.

So why have the shares dropped 20% since the latest results were released in early May? Primarily, that's down to component shortages triggered by a pickup in demand from many other high-tech sectors, such as consumer electronics. But I still think the recent earnings miss should simply be a temporary setback.

I rate the stock on ten times the 2011 Ebita multiple. After adjusting for the e0.5bn of net cash, the e£2.5bn pension deficit, and discounting back at 12%, that generates an intrinsic worth of about e3 per share.

As for catches, in addition to having to execute the recovery plan, Alcatel is exposed to price deflation, intense competition, foreign currency shifts and component supply issues. That said, the euro's drop against the dollar has made the firm a lot more competitive internationallly. And with internet usage going through the roof, together with the emergence of 4G technologies, Alcatel is a good play on the future growth in optical communications. Soleil has a e4.00 price target.

Recommendation: BUY at e2.00

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