Alcatel-Lucent (ALU) Q2 2012 Earnings Conference Call July 26, 2012, 07:00 a.m. ET Executives Ben Verwaayen - CEO Paul Tufano - CFO Analysts Kai Korschelt - Deutsche Bank Simon Schafer - Goldman Sachs Sandeep Deshpande - JP Morgan Achal Sultania - Credit Suisse Alex Peterc - Exane BNP Paribas Vincent Maulay - Oddo Securities Anuj Krishan - UBS Sebastien Sztabowicz - Landsbanki Keppler Stuart Jeffrey - Nomura Presentation
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Good morning, good afternoon, good evening, depending where you are. Thank you for joining us on the Q2 call. As always we have for you the safe-harbor and you can read that as your leisure. So let's go the business at hand. Our Q2 results, basically more than the Q2 results are kind of, so what of the results of the first six months. Because it’s only six months ago that we told you that you should expect for 2012, a better result than 2011. So this is totally changed where we are in today. I think it requires sound, frank and transparent analysis.
So if we look back three years ago. When we set out ago in doing what we have done, I think we -- it’s safe to say that we have accomplished some but not all. We have great businesses. If you look to core activities, or core network, IP, next generation optical, cloud service on top of that, it’s an amazing business proposition, value proposition recognized in the market. IP grew this quarter 16% in a market that is absolutely very, very scarce on growth.
If you look to where the other portfolio is, and I am pretty sure that you will see it when Paul makes his presentation, where the actual sales is. More than half of our business is now what we call HLN, so stuff we didn’t have a couple of years ago, actually it’s 52% in the quarter. So that part of the business is working. If you look to our relationship with customers, we have customers that you could describe where we are supplier, but we have also many customers where we are truly a partner. Not just from the value that we give them today but also in developing together with those customers, the roadmap for the future.
Now that’s not across the board and I think if you look to the financial performance of the last six months, it has not been acceptable. And that means that you have to look to where you are and face reality, and probably also plan for reality, not to change dramatically any time soon. And that’s what we are here to discuss today. Because the fact of the matter that our Q2 was not at the expected level is in by itself just a data point, but it is the trigger point to say we need to change. We need to take firm action. And we need to take firm action now.
The action we are going to take is twice as big as we have done before and will be twice as fast. We did over the last three years, 1.2 billion in cost saving. We are going enough, call it 18 months, at least at the moment. And it’s more than cost saving, we have to look to the structure of our choices. And the structure of our choices means that you have to, and I have not said this before and I say it here for the first time, you have to admit that you can't be everything for everybody everywhere. And that means that you have to make those choices.
And that’s necessary if you want to achieve, I would say a business model that has the capability to produce sustainably profitability for the company. A sustainable profitability for the company is the aim which you need to have, because all of the other points derive from that sustainable profitability for the company. So are we facing a very difficult market? Yes, we are, and so do our competitors. So from that, it’s more a given than an excuse. It’s a given. And the difficulty in the market has been, I would say underestimated by us otherwise we wouldn’t have given the guidance in the beginning of the year. And the underestimation, if you look today’s paper say you open the paper, you look through what happens to our customers, you understand that there is a big reluctance in the market that translate into two-fold.
It translates into, I’m only going to spend what we absolutely have to spend, but important for us it also say I stay in footprint. I rather than upgrade in a technology refresh, I’d rather stay with today’s technology and give it another tweak of life and that I’m going to have the innovation part.
Our portfolio orders, our order book is pretty good. And a lot of those orders they are postponed in the translation to sales, because of this effect. And I fully understand that, I accept it and it is something that I think we have to take into account that will not be just a one quarter event.
So, what we have to do is we have to create a performance capability, the company recorded the performance program. The performance program has to look to more than just cost. Cost is very important. The reduction of 1.25 is as I said for us unprecedented and the speed in which we are going to execute it will echo that. That’s a reduction target, but by reducing this, you also have to look where they are reduced. But we will exclude R&D.
R&D is the core capability of this company, we are a technology company, it's a choice we made. We are an innovation company, we will protect that part. So, we will attack our cost structure in the rest of the organization, which is SG&A, which is the fixed infrastructure in the organization. And we go is the same type of vigor to our variable cost, because in a markets that will translate the pressure not only a reduced stop lines but also pressure on the margin in that market. The way you handle your variable cost is as important as your fixed cost.
So, unfortunately you cannot reduce your cost on this level and of the fact the people. So, we have to announce today a people reduction program of 5,000, 5,000 just to give you a feel for this, on a population in SG&A that’s approximately roughly 50,000. So, it is a severe cut in our infrastructure and we will have an effect on the way we organize ourselves because you cannot just take 5,000 people away and think that, if you work a little bit harder the rest will continue. It won’t. I will come back to that when we are ready to talk to you about that.
We also will look to our contracts. Some of our contracts especially in managed services especially where we do maintain and operate. There are contracts there that we will give a second look. We look at geographies, we look over assets, and the timeline is given by the end of 2013 everything needs to be done.
But let’s go one-by-one, cost of people. We had a program and you know the progress of the program. We are on track for that program of 500 million. The big on track for that program is not good enough anymore. So, whilst I command the people in the organization, who have really executed well on the cost program that we have announced in November 2011, you will (inaudible) as we need to accelerate.
So, the new cost program will ask for a 1.250 billion of saving. And it will be executed in a very transparent way with the rest of the organization, because it will in fact [old parts] of our cost structure that we have. It will include the 5,000 people which is across the board (inaudible) affected. And it will accelerate the pace of our transformation. So, that means that we have to reassess the business model or the operating model I already talked to you about that. And we will do that in a very, very speediest way, because if you want to capture most of the advantage, speed is of the essence.
And as I said, as a global program you need to be totally transparent in that. So, that means that we aligned the structure with scale. Now to our different scales and different set of the business. In our core network capability, so there is a different scale within the scale business itself, where you have to look to a very different way of going to market and a very different way in the reception of new technologies. Because if you have a few boxes that make the difference or you need to have thousand and thousand of the same boxes if you need to deploy, that makes a very big difference in how you deal with it. So we will make sure that we look into the dynamics of each of the business. But one thing will be for sure in the rest of the organization, we will cap management layers throughout.
To simplify the organization because if you, as you will see, we do cut the number of [dockets] you are in, and you cut some of the portfolio issues that you have, then you have the ability to simplify your structure, which is a benefit that we need to have. And we reduce our variable cost, you know that program almost by heart here in the company.
Now managed services, we have 68 contracts around the world. We have 14,000 people. It’s around 1 billion in revenues and we have, let's say 25% of those contracts will be up for review. So that means that the various outcomes, you can renegotiate the terms. You can exit the contract. You can expire the contract, but you need to deal with the financial consequences over that. And I think that it will have pretty rapidly a positive impact on what we do on the bottom line. And we will focus, make no mistake about it, on the higher value services part of our portfolio where we are very successful.
If you look to cloud services, we are doing very well. If you look to system integration and professional services, we do very well. So it is about looking to the specific contracts in the specific elements of our business portfolio. Now, if you look to geographies, this is an interesting chart because I think most of you will say, this is not something that just happened yesterday. And that’s true. The top 60% of countries represent 96% of what we do. And I think many, many companies have that.
Now we are a tier one supplier. A tier one supplier because of the depth of our portfolio. The relationship we have with companies around the world and we will stay that and defend that. That is our DNA. Its technology innovation and being the tier one. Up till today, the translation of that was, that means that you need to go wherever the market is going and that means 130 countries and territories. Maybe, maybe not. But we will have to bite the bullet in making sure that we make our choices. We cannot be in all of those bottom 40 that represent less than 1% on our own. So we will change that. And sometimes that will be painful, and I admit that.
We will adapt our go to market strategy, which means that sometimes we will have channels, maybe in pre-sales. That could also help the way that we manage our cost structure for some of those markets. Now an interesting part is assets. You know that we have been engaging ourselves with [RPS], we talked about that. That has been a very fulfilling collaboration. I would say the experience has told us a few things. Experience has told us that our patent portfolio is highly attractive, highly attractive.
At the same time it also tells us that if we compare ourselves with more colleagues in the market, that the leverage of that patent portfolio is rather poor with the 140 million. You can see that in the 20-F. So, I don’t think that I give you any secret here but the 140 million contrast quite weak, is what some of our colleagues in the market are doing. So we have decided this is such an important part of our DNA, who we are. Monetizing the way we monetize this asset is also pretty important to portray the same aggressiveness as we have to go out for our cost to go after defending the assets that have and monetizing it in a positive way.
So we are going to create a profit center in the organization to make sure that we do the right thing with the 29,000 patents. And that is a -- we will have a substantial change in the (inaudible) that we have in the market.
Now if you look to all of these things that’s not all we are going to do. It's all I’m ready to talk about today, but you will be not surprised given what we are, we will take the logical consequence of the actions that we have here today, and pull them through to the rest of the decisions that we have to take. And why do we take these decisions, because this is the long-term operating model that I propose.
We should be a company that is focused on its customers as [a partner] and we should be focused on the profitable market segments. There where we can make a difference, from a technology point of view for our customers, and from an economic point of view for ourselves. We must be able to translate not on the longer term, I do this because maybe later we will be profitable, but on the much shorter term must be the translation between the added benefits for the customers and economic benefit for us.
That means that we need to maintain a strong innovation engine. That’s a choice. It's a fundamental choice, you could choose to be a quick follower, you could choose to be the price leader, we choose to the innovation leader. That’s our D&A that’s what we have in the capabilities that we have in the more I’d say successful part of our business.
The adequate cost structure need to be there. And you cannot have a cost structure that is out of line with the scale that you are in. So, that’s the admission. And we need therefore, to get a better leverage from our internal assets. If you do the steps that we have in our program, our performance program will deliver the tools to go and bring this to life. And we think we can do it rather quickly. And we are absolutely determined to go and deliver on that.
So, I have talked about everything about the quarter, Paul if you would talk about the quarter, I think will be good. Thank you.
Thank you, Ben and good afternoon. Let me turn to the quarter, obviously we reported our results this morning and from an accounting standpoint we reported a loss of 254 million or Euro 0.11 per share. You should note that included in that loss is a 177 million charge or the series we convert from Lucent that will be maturing next year. Since it was convertible debt (inaudible) it's now in a period of one year, we recharacterized the cash flows to make it long-term debt and that has negative impact of Euro 177 million and you see that in financial income. Outside of that everything else is relatively consistent as we said before.
Turning to the adjusted operating margin. Approximately 10 days ago we gave a pre-announcement. We came online with the revenue and our Euro 3.545 billion. The loss we talked about previously of 14 million, we slightly improved on to minus 31.
If you look at the revenue you can see that, that actual rate is about 7% reduction year-on-year and 11% quarter-on-quarter. When you normalize for currencies, it's 13% year-on-year reduction and a 10% growth quarter-on-quarter.
In view of the gross margins. Gross margins are down 3.2 points year-on-year, they are up 1.4 points to the first quarter. As we look at the year-on-year decline is exclusively volume and product and geographic mix. That’s been offset by reduction in fixed cost and expense.
On the quarter, you see 1.4 points improvement that is all volume and fixed cost reduction. Now clearly, we are disappointed with the gross margins, we would have hope to been closer to 33% or slightly over. The entire delta to that 32% from 31.7 is primarily volume and geographic mix.
As we look at operating expenses on a reported basis they are down 70% year-on-year, when you adjust for currency that’s 12.5%. With SG&A being down at adjusted basis 14.6% and that is consistent with the actions we have been taking our fixed cost and expense structure. We are on track, we are slightly ahead of plan for those expense reductions and that you can see on the following chart.
We have over 100 million year-on-year savings this quarter, compared to the quarter a year ago. This is total fixed cost and expense in constant currency with a constant variable compensation assumption. So there is no changes because of currency and the like.
The dominant contributors to the reduction come from, again, the SG&A actions and also the actions we are taking in fixed cost. If I look at revenue by operating segment, if we look at our networks business, you can that at constant currency it is down 16% year-over-year, and up 11% quarter-on-quarter. Clearly within that there is a great deal of mix. Our IP business is growing 8% at constant currency. Both year-on-year and at quarter-on-quarter. That’s driven primarily by our IP business. And with the recent announcement of our XRS router, we are seeing continued interest in the entire portfolio of the IP business.
Optics is down approximately 19% year-on-year and up 10% quarter-on-quarter. As you know there is a submarine business on optics and there is the threshold optics. Submarine is at the low point of its cycle. It is down 32% year-on-year, but as look at bookings and winnings, and wins are new cable installations, we are very comfortable that it will rebound in 2013. Threshold optics is down 13% year-on-year, primarily driven by legacy products, where were down 36%. The VDM product and our wireless transmission were relatively resilient this quarter and year-on-year.
In wireless you see we are down year-on-year about 26%, they were up 10% quarter-on-quarter. The predominance of the year-on-year decline in wireless is CDMA as one would expect. And some other third generation products. LTE is up 264% year-on-year and has grown 17% quarter-on-quarter. In our wireline business, you see it at about 9% year-on-year. When you strip out the legacy business our PON products have grown dramatically at 93% year-on-year and 51% quarter-on-quarter. So it’s then indicated some very strong strengths in new technologies in our portfolio as it relate to addressing customer situations.
In the high leverage network products we are 52% of our overall network revenue and we have 9% growth on year-on-year. In our services business, 6% down year-on-year, 8% up quarter-on-quarter. And as you look through that, it is primarily driven by -- year-on-year by network applications and here we are seeing some deferrals year-on-year for messaging business, our SDM business and our IMS business.
Enterprise did fairly well. It was down 4% year-on-year but up 7% quarter-on-quarter. In the enterprise we saw a very good growth in data. 2% year-on-year and over 17% quarter-on-quarter. Voice was nominally in the year and up on the quarter. Turning to margin by segment. You can see that the big swing year-on-year was in networks, a 105 million, and the predominance of that was in wireless and was tied to the drop in CDMA. That was slightly offset by improvements in both wireline and IPD. On a quarter-on-quarter basis, networks improved 86 million at constant currency. And that was by strong contributions from both IPD, wireless and wireline.
Our services business was up 100 million, roughly quarter-on-quarter, flat year-on-year. That 100 million growth was primarily in maintenance. It was 43 million growth from our managed services business as some of the actions we are taking are beginning to take hold. As well as some growth in professional services. If I turn to revenue by geography. Our this piece of revenue from last year is approximately the same with North America, approximately 40% and the rest of the world is 60%. If we look at North America we can see we are down 18% year-on-year. And I have to remind you that last year the first half was extremely strong in North America. And so it’s to a very high comparison.
But we have grown 2% year-on-year in North America. Today Verizon and AT&T continue to be top ten customers. If we look at our Asia Pacific business, it is down 14% year-on-year that is predominantly China, because of the deferral of special bids in China, normally through the first quarter has been fair amount of deferral through the first half. China is down year-on-year 22%. We did see strong recovery in the second quarter, albeit not to what we would like and we believe the second half will be stronger than the first in China by significant amount.
If we go to EMEA, you can see it is down 16% year-on-year, quarter-on-quarter that’s grown 24%, and the predominance of the decline is in Western Europe, as you would expect given the spending patterns of Western operators.
The real bright spot is in CALA, you can see the rest of the world has grown by 9%, rest of the world is composed of both CALA and Middle East Africa. Latin America and South American unit has done exceptionally well over the last several quarters, I think seven quarters in a row. We have seen a 30% growth year-on-year in South America primarily driven by growth in Mexico and Brazil. But we have seen the Middle East and Africa show positive growth quarter-on-quarter, so we are seeing some beginning of momentum in the Middle East and Africa.
Turning to the balance sheet, quite frankly there is only two changes in the balance sheet; one is FX, given the strengthening of the dollar toward the during the course of the quarter you see a lot of FX movements in the line items. The only one I’d point out other than FX is you can see there is a billion roughly a billion Euro increase in pension and it will have liability offset by shareholder equity. As you see the discount rate declined by 50 basis points during the course of the quarter, that increase their liabilities and that’s the driver of liabilities they offset and shareholder equity. And that is no real change in the balance sheet.
On operating working capital. Actually, where you see operating working capital increased by 108 million and we adjust for currency it's approximately the same number to 110 million. The driver of that is inventory up 97 million quarter-on-quarter.
That inventory growth is attributable to the growth in the Americas associated with the build out of new networks for customers. It was offset to some degree by reductions in our overall operations inventory number. If you look at our receivables, (inaudible) approximately 80 million at constant currency quarter-on-quarter. The reason for that quite honestly is if you look at our second quarter, it was very backend loaded, a lot of our sales took place in the last month and especially the last two weeks of the quarter and we had a fair amount of receivable growth associated with that. Our discounting level actually was flat quarter-on-quarter, in fact it was slightly down. And we saw about 65 million increase in payables in the quarter and that drove one-tenth.
If I turn to cash flow, obviously this quarter was a bit disappointing us from a cash flow standpoint. We consumed 511 million of free cash flow. The two primary drivers for that were obviously the adjusted operating margin which was a minus 31. We had hoped that to be positive ad a net change in working capital which is a consumption in cash of 182 million again primarily driven by receivable and inventory growth.
You will note on this chart other working capital is a negative 188. And that is variable compensation. We pay our variable compensation one year after, it's earned and this is very predominantly variable compensation payments for the entire corporation that were paid out in the second quarter.
Other than that, the other items of the cash flow statement are pretty much in line, restructuring was 80 million, consumption of cash that puts us at 162 for the half, we guided you to around 400. So, very comfortable, we will be in there in with the new restructuring actions we will take. Our CapEx is 130 million approximately half of which is tangible CapEx, the rest is capitalization R&D. That puts us at 253 the half and our guidance was around what we did last year which is 600 that should not be an issue.
During the course of the quarter we repaid 15 million of debt, and we ended the quarter at 5 billion of cash and marketable securities.
Our credit facility at 837 million is undrawn and all the covenants are met. And finally, as we go to pensions, from an accounting basis, you can see that the underfunded status of the pensions increased approximately a billion euro quarter-on-quarter. That’s all attributable to the change in the discount rate of 50 basis points. That drove about 1.8 billion worth of additional liabilities. Our plan assets actually grew by 900 million and that’s the result of the difference.
Now, as we stated before, for the U.S. pensions, what determines funding is compliance to the ERISA statutes in the U.S. In early July, there was a change in U.S. legislation. That change in U.S. legislation allowed for a stabilization of interest rates to be used for the calculation of pension liabilities, using a 25-year quarter. Taking the legislation as it’s been signed and extrapolating it to our pension portfolio, we believe there will be no funding requirement for any U.S. pension until 2016 at the earliest.
In addition, that law also had a second provision which is very beneficial to Alcatel-Lucent, it allowed for the extension of the 420 statute, which allows you to use excess pension funds to fund retiree healthcare. It also has been extended to allow you to fund retiree life insurance. And that change will probably give us a positive 600 million of additional asset liability and reduce pension liabilities by that amount. So the pensions are in excellent shape.
And finally, before we conclude to turn to Q&A, our outlook for the quarter or the full year is that adjusted operating margin in the second half is better than the first half. And we target strong positive net cash full year in 2012. And with that we will open up to Q&A.
Vincent Maulay - Oddo Securities
Vincent Maulay from Oddo. Two questions. The first one is a clarification on plan. So we talked about 5000 job cuts for €750 million savings on normally the job cuts. I mean roughly €500 million of savings. So the incremental it’s on variable costs. So could you give us more color on where you will find new variable cost to adjust? And the second question, why are you deciding to stick with all your product segment, just when Nokia Siemens, for example was able to sell loss making assets at a decent price. So if you have sustainable profitability skill, why not dispose some assets?
So with regard to the cost savings. On the 750 as you said there is 350 million in variable cost, 400 million in fixed cost. The 500 headcount reduction primarily relates to the -- the 5000 headcount probably relates to the 400 million of fixed costs. As we look at our variable cost reductions, you know a lot of that is sub-contracted work. As you go into the field, especially there is a number of subcontractors used in a lot of these countries. So you will actually see a FTE reduction. He probably won't be an Alcatel-Lucent employee.
Now in addition, if you look at the managed service contract, there is 14,000 people associated with those managed service contracts. There most likely will be reduction in that number of FTEs. That would be either contractors we use or own people, it would be additive to the 5000.
All that will go is the contract to an ex-owner. So as we have seen, this is not the first time we have done this. You sometimes get the new owner of the contractor that take the people with them. So they get the different employer. And that’s why we haven’t put that in the number. The number of 5000 is clear, what we need to do, we need to take action and it relates to the fixed cost. I don’t think that I have said anything that would preclude which you just suggested. I have not said that would confirm what you said.
We have been tweaking our portfolio already a lot with last couple of years, because it’s not just the headline. Most of the complexities within the portfolio, you can say wireline, but in wireline you have maybe seven or eight different families of products. And I think what we have said is we will take a good look and I think I have said a few times, the structure of our business and I’m pretty sure that elements that you said will be part of that.
Next question comes from Kai Korschelt from Deutsche Bank. Please go ahead.
Kai Korschelt - Deutsche Bank
The first one was just on how much revenue could you potentially loose from exiting geographies and restructuring new contract. I think you indicated maybe two quarter ago, billion in managed services, but how about the equipment business. And also my other question is the margin structure on those resale product, will that be typically lower or not. And then the second one really on European wireline, I’m just wondering if you are seeing any signs of pickup it looks like your comment at least on the (inaudible) suggesting that there is already some spending improvement or is that really just isolated on the router side and on the optical side, we have to wait a little bit longer.
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