F5's Market Cap Surpasses Alcatel-Lucent's

The price spike after F5's (FFIV) earnings call last week pushed its market cap over $6.5 billion, surpassing industry stalwart Alcatel-Lucent (ALU), which was at $6.2 billion after yesterday's close. This is an absolutely remarkable development for the networking industry, and shows how important it is to stay focused on industry sub-segments where you're either #1 or #2.

If you think of some of the highest revenue product categories in networking, from core routing to Ethernet switching to 4G wireless, Alcatel-Lucent is in every one of them, while F5 is none of them. So why is its market cap higher?

F5's valuation is a little rich, but certainly not wildly out of control in a 1999 sort of way. It has $780 million of cash and investments, no long-term debt, $40.5 million in net income last quarter, and a $6.9 billion market cap as of yesterday's close. Net of cash this gives the stock a P/E of 38 on annualized earnings, which is lower than its 46% top line growth rate over the last 12 months, and its nearly 90% bottom line growth for the last year.

Excessive optimism is not really the cause of F5 leaping past Alcatel-Lucent, but tremendous focus is. The company does not have an offering in any of the major networking categories, but it is a leader in a growing niche. Alcatel-Lucent, on the other hand, participates in just about every major segment, but leads very few. And its financial reflect this. Its gross margins have been hanging around the low 30s, while F5's have been pushing 80%. While many of the telecom products Alcatel-Lucent offers sell for lower gross margins due to high raw materials costs, Infinera (INFN), which is focused entirely on the low gross margin optical sector, is now posting higher gross margins than Alcatel-Lucent.

Still Recovering from McGinn-Russo
The current challenges at Alcatel-Lucent really have little to do with current management, and in fairness to the new executive team, they have been very focused on reducing overheads and trimming expenses in spite of stereotypes about bloated French bureaucracies. The company's SG&A/Revenue ratio is down to 21%, lower than many of the smaller vendors. Moreover, just 12% of the company's workforce is in France.

Alcatel-Lucent's challenge is the incredibly diverse set of products it must manage, which in part reflects the wild acquisition and over-diversification of the McGinn-Russo era at Lucent, as well as the old school approach of being a supplier who does everything for its telecom customers. This is one reason why its gross margins are low, it has long inventory cycles and must support production and development across a wide range of data, optical, and wireless products. F5, on the other hand, has never tried to have a high "share of wallet", because much of its customers' equipment spending goes to routers and Ethernet switches, neither of which are in its product catalog.

Ten years ago, it was said that startups had no shot at competing against large suppliers like Lucent, Nortel, and Alcatel at major carriers. While this was factually true, it concealed the fact that there was little economic value to being a diversified telco supplier. Even Cisco (CSCO) struggled to break into the carrier market, and scaled back its optical ambitions when its killed its optical switch acquired through Monterrey, and it never even tried to get into 3G or 4G wireless.

Alcatel-Lucent still leads some product categories, notably DSL and Fiber-to-the-Home. Nonetheless, it still needs to trim down its offerings if it wants its market cap to catch up with those vendors generating higher gross margins by offering fewer products.