Alcatel-Lucent SA (NYSE: ALU) was downgraded by Merrill Lynch to Underperform from Neutral. This was effectively the opposite of what Credit Suisse had done in the previous week when it raised Alcatel-Lucnet to Outperform from Neutral.

Merrill Lynch believes that the current share price discounts an overly optimistic scenario of normalized free cash flow and EBIT generation capability in 2016. With meaningful revenue growth headwinds and low underlying free cash flow improvement, excluding the benefits from factoring, the firm views the risk/reward relationship as unfavorable.

The price objective for Alcatel-Lucent was given in Euros as 2.4, and US investors looking at the equivalent downside for Alcatel-Lucent ADSs trading in New York should know that this implies a downside of roughly -16% at current prices without trying to convert euros to dollars.

Analysis on Alcatel-Lucent would show that the company’s free cash flow has not meaningfully improved on a LTM basis, excluding the benefits for higher factoring. Accordingly, this would imply that the stock is trading at a valuation discount compared to its peers. However, on both free cash flow and price-to-earnings metrics the stock trades at a premium versus its peers.

Merrill Lynch’s Kai Koschelt and Adithya Metuku detailed in the report:

2015 should be the ‘final year’ of Alcatel’s successful SHIFT turnaround plan as management will likely deliver on planned cost savings. However beyond 2015 Alcatel will need to deliver mid-single digit revenue growth in order to continue to grow EBIT/earnings per share at high single digit % and deliver free cash flow expectations baked into the current share price. We view such a scenario as optimistic given three major top line headwinds: 1) ‘Lower for longer’ US capex (32% of revenues) due to slowing 4G rollouts, rising leverage at the carriers and the secular shift to SDN/NFV driving lower capital intensity & risk of share loss for incumbent suppliers. 2) Declines in legacy products which we estimate make up ~20% of group revenues. 3) A likely peak in China capex in 2015 (12% of revenues) followed by decline in 2016.

The ADSs of Alcatel-Lucent in the U.S. were down 3% at $3.38 in the last two hours of trading on Monday. The ADRs have a consensus analyst price target of $3.94 and a 52-week trading range of $2.28 to $4.51

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