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Unloved telecom stock curiously gets top rating

Value-focused Morningstar evaluates stocks based on their underlying fundamentals and then calculates the securities' fair value based on cash flow, safety and peer valuation. The research firm favours unloved, cheap securities. It recently added Tellabs , a telecom-equipment company, to its five-star stock list.

Morningstar awards just 21 stocks a five-star rating. Tellabs, one of the worst-performing S&P 500 stocks of 2011, has dropped 33 per cent this year and 45 per cent over a 12-month span. Morningstar says the company, which sells its products to network telecom service providers, including its largest-customer, AT&T, is undervalued. However, Tellabs competes in a competitive market and isn't a so-called domain supplier of AT&T, which is disconcerting, given that roughly 35 per cent of 2010 sales came from Ma Bell. But, there are other positive aspects to offset this risk.

Tellabs carried $1.2-billion (U.S.) of cash and $180-million of debt at the first-quarter's end, for a net liquidity position of nearly $1.1-billion, a quick ratio of 2.7 and a debt-to-equity ratio of 0.1. Although the company has been struggling as of late, suffering GAAP net losses in the past two quarters, its balance sheet should buy it plenty of time for a turnaround. Tellabs swung to an adjusted first-quarter loss of 3 cents a share, missing the consensus forecast, albeit marginally. Sales fell 15 per cent, also missing consensus, sending Tellabs' shares down 9 per cent in reaction.

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Tellabs is pouring money into mobile Internet research and development, boosting investment 16 per cent in the first quarter, now equivalent to an eye-catching 25 per cent of sales. While management is taking aggressive action, it suggests the current product portfolio is waning in relevance, hurting sentiment for the stock, which has fallen to a 52-week low. Of the 23 sell-side analysts covering Tellabs' shares, just one rates them a "buy." Tellabs ranks as one of the worst-rated stocks in the S&P 500. It is notably cheap, selling for a book value multiple of 0.9, a sales multiple of 1.2 and a cash flow multiple of 12, 71 per cent, 70 per cent and 47 per cent industry discounts. But, value is no guarantee of performance.

Morningstar, which isn't beholden to a 12-month timeframe, as the sell-side is, values the equity at $7, using a free-cash-flow model. That implies a return of 55 per cent, if the stock returns to Morningstar's perceived fair value. Morningstar concedes that the rest of 2011 may prove challenging and the unloved stock may tumble further, given recent bad economic data, terrible technicals and no near-term catalyst. Last quarter, Tellabs' product gross margin decreased from 54 per cent to 41 per cent and its services margin narrowed from 31 per cent to 19 per cent.

But, the ramp in research spending, enormous relative to peers, could be a long-run boon as network operators cope with bandwidth consumption at peak hours, especially as customers upgrade to smartphones and tablets and engage in activities such as movie streaming. Morningstar sees Tellabs "working toward a model where its hardware will have a larger software component that will allow carriers to manage traffic Layers 4-7, and as we've seen from other companies that provide hardware and software to manage traffic at these levels (F5 and Acme Packet, these products can carry very high margins."

If Tellabs can grab market share in this fast-growth industry, it could become an outstanding turnaround stock in the longer term. If that thesis doesn't play out, Morningstar sees the company as "a potentially attractive acquisition candidate, whether for its technology portfolio, its North America customer base, or both." Predicting the trajectory for Tellabs is tricky, but assuming that the smart phone/tablet trend persists, there will be strong demand growth in the traffic backhaul arena and the company has a shot at redefining its business and margin profile.

Morningstar points to the recent acquisition of WiChorus, a tech firm that helps "get wireless traffic from cell towers to the core network" as a lucrative addition to the product lineup. Also, financial restructuring should help the company stay afloat as its focus shifts. Moves, ranging from facility consolidation to production outsourcing, are likely to trim Tellabs' cost structure, going forward. This process is nearing its conclusion and may mean more stable, and profitable, operating results. Pricing is likely to stay very competitive, limiting margin upside.

With $3 of cash per share, investors are really paying just $1.51 for Tellabs' growth prospects. This remains a risky call, but should the market continue to correct, as it did yesterday, Tellabs may be a worthy stock for risk capital. Also, the board pays quarterly dividends of 2 cents a share, which translates to a yield of 1.8 per cent.

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