Alcatel Grabs For Xylan

The French telecom equipment maker has a long way to go to appease Wall Street.
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The Pepe Le Pew of European telecom has caught its painted cat.

Alcatel

(ALA)

, a Parisian builder of telephone gear, said Tuesday it will buy the Californian computer networker

Xylan

(XYLN)

for $2 billion, or $37 a share in cash.

Trouble is, some analysts are holding their noses.

A year ago, U.S. money managers viewed Alcatel as an emerging powerhouse. But the company, privatized by the French government in 1987, has recently stumbled in the global marketplace.

Last September Alcatel warned of slowing profits, which came as a surprise to Wall Street. The news sent the stock down to 19 from 31 in a single day. At the time Alcatel blamed a worldwide shrinkage in capital expenditures, but this analysis lost credibility as

Lucent

(LU)

and others met their earnings goals later in the fall.

Last year Alcatel recorded $25 billion in revenues, up slightly from $23.6 billion the prior year. Profits soared to $2.7 billion from $800 million, partly due to the sale of its

Cegelec

systems integration unit. A

First Call

survey of equity analysts predicts Alcatel will earn $1.07 per share in 1999, marking a 27% decline from the prior year. Last September, the consensus estimate was for the company to earn $1.66 per share. No wonder the stock is off 40% since then.

Given that money managers still hold a grudge against Alcatel, today's acquisition generated enthusiasm mostly from the speculators who had bought Xylan shares early last week on takeover rumors. That speculation had been discernable in the options pit; daily options volume for Xylan more than doubled on Friday and Monday, and mostly consisted of speculative call buying (in anticipation of a takeover), according to

McMillan Analysis

.

On Tuesday, the speculators redoubled their buying and then cashed out. Almost 30 million shares changed hands, as the stock rose to an intraday high of 36 3/8. Many investors are turning a quick profit on this one, rather than betting on the fundamentals.

Investors who snapped up shares last Monday when Xylan was trading at around $20 have already exited their positions, says one institutional trader. By the market close, Xylan had fallen to 35 3/4, up 8 13/16. Alcatel closed the day at 21 7/8, up 1/2.

Why are Xylan shareholders worried about Alcatel?

The two stocks have different flavors: Xylan was a growth story, as well as a takeover candidate. By contrast, Alcatel appears the lumbering European giant trying to reinvent itself and appeal to value investors.

Among networkers focused on corporations, Xylan is a nice catch. Last year, Xylan sales jumped 65% to $348 million and profits also roared 64% to $39 million, beating the growth rate of networker

Fore Systems

. But Xylan still commands far less respect than industry leader

Cisco

(CSCO) - Get Report

, which grew sales 37% to $10 billion in the four fiscal quarters ended in January.

"I always have thought of Xylan as being the

Rodney Dangerfield

of networking," says Dave Passmore of the consulting firm

NetReference

.

The deal is "an incremental positive" for Alcatel, says analyst Walter Piecyk with

PaineWebber

, who started coverage of Alcatel with a "neutral" on Feb. 17.

The key problem is that Xylan doesn't supply many large carriers with advanced Internet gear, which is exactly what Alcatel needs in order to secure long-lived contracts in the U.S., says Piecyk. Lucent and Nortel have had Xylan-type gear for a while, and are now focused on supplying carriers with Internet gear. Alcatel is playing catch-up.

Alcatel already has indigestion with its September acquisition of

DSC Communications

, a Dallas-based supplier of subscriber-line gear for local phone companies. Sales at Alcatel's DSC unit shrunk 20% in the fourth quarter, Piecyk figures, and it risks losing business with

Motorola

(MOT)

. On Monday,

Sprint

(FON)

said its tests show that Motorola wireless stations can operate with switches from

Lucent

(LU)

and

Nortel

(NT)

. "There's probably very little need for Alcatel switches," notes Piecyk, whose firm has no banking ties to Alcatel.

An Alcatel official says Motorola just inked a four-year, $1 billion contract with Alcatel. He declined to comment on DSC's performance, but says last year Alcatel increased its overall sales in the U.S. by 50%. (Excluding DSC, sales were up 35% year over year.)

As in the Nortel-Bay Networks and Lucent-Ascend mergers, Alcatel must integrate workers who are separated by distance and training. "The biggest challenge is not technology, it's culture," says Passmore. Internet engineers and sales representatives just move faster than phone guys, he says.