I'm a bear on Lucent (NYSE: LU) because I don't think it offers enough reward. I want super potential returns when I undertake great risk, since I can always buy a total stock market index fund and match the market, snoozing all the way.
The risks for Lucent are that it will not succeed at its turnaround, ending up in Chapter 11 bankruptcy or selling itself for peanuts. But the best scenario for the company is that its restructuring and asset sale plans may give it enough cash to pay down a significant portion of debt and limp along while telecom sales sag, leading to a buyout at a modest premium to its current share price.
That's its best hope: a buyout at a small premium. Woo-hoo.
Lucent's turnaround
Even the best scenario for Lucent requires you to believe that management has the tools to turn around a company that has nearly been destroyed by previous management, whose actions were revealed when the market for the company's products tanked. This requires four things: Excellent current management, which has the human capital to use adequate financial capital to design, produce, and sell products at excellent margins to a growing market.
This list is based in large part on contributions from the TMF community, to whom I turned for help. Thanks to EddieBo, sonofed, kleks, michaelzehr, poncho9191, 3gnuts, and pterodactyl for raising strong bull and bear arguments. They are responsible for cogent arguments only, so please lob the tomatoes at me for forgetting anything, errors of fact and omission, and just plain thick-headedness.
The story, in short: Current management is okay but unsettled, human capital is demoralized, debt is an issue and convertible preferred debt a threat, and the market for Lucent's telecom products -- while it will certainly recover -- will not be enough for this business to provide market-beating returns (to satisfy my risk-reward need).
Management
The Board showed former Chairman and CEO Richard McGinn the door last October, replacing him with Henry Schacht from Lucent's enterprise networking spinoff, Avaya (NYSE: AV), as interim CEO. Schacht was Lucent's CEO from 1995 to 1997, so he isn't starting from scratch. But he is interim, and that has to limit his ability to make changes and achieve all the benefits of the reorganization plan. A new, strong leader must be found soon, or Schacht has to be made permanent.
Human capital
Of course the company has no choice but to roll heads. On July 24, Lucent announced another 15,000 to 20,000 layoffs to its 74,500 workforce, down from 106,000 before the optical fiber sale and plant closures. Well and good, but any company that has had earthquake-esque layoffs will not turn on a dime. Retirement incentives do not distinguish between the star and lesser performers, and anyone who thinks that a company's morale can recover in a short period of time is deluded. Shorn of cash available for incentives and a stock with uncertain prospects, the company lacks the ability to retain or attract talent. Those who stay must be convinced within a relatively short time that management is accomplishing its goals with a clear plan.
Debt and dilution
Let's drink the magic Kool-Aid and say that management does well and employees rally. There's still the little matter of The Debt. Paul Larson followed the June downgrade of Lucent's debt, and more has been issued since then.
What particularly caught my eye was the recent $1.9 billion sale of convertible preferred shares. These are convertible at $7.48 and paying 8%. Apart from the high interest rate -- convertible preferred usually offers a lower interest rate in exchange for the potential gain from the stock -- it represents significant future EPS dilution of 8.6% from new stock alone. That's about equal to Lucent's share increase for the last three and a half years from all sources.
So a potential shareholder today not only depends on management to accomplish restructuring and attract and retain key employees, but also accepts the risk of the overhang of debt and dilution. And that's before even getting to whether the Lucent that survives after the spin off of Avaya and Agere (NYSE: AGRA) and the sale of its power systems and optical fiber operations can develop, manufacture, and sell innovative products to a market that at some point recovers.
Market
Right, you ask, what about all those nifty products? This is Bull Bill Mann's bailiwick. The guy co-founded an up-and-coming telecom company at his kitchen table, for crying out loud. Undoubtedly he extols Bell Labs, higher margin communications software, and the return of customers for Lucent's optical networking equipment. Ix-nay! With the first pieces of this puzzle -- management, human capital, and debt -- Lucent's products aren't going to get the development, manufacturing (even with the move to outsourcing, such as with Celestica (NYSE: CLS)), or sales support they need.
Go ahead and ballyhoo Lucent's nifty CDMA wireless communication hardware and software products, and significant contracts for them with Verizon Wireless (NYSE: VZ) and Sprint (NYSE: FON). Put a happy face on Lucent's slow catch-up with research and development and products for OC-192 (10 gigabits per second) and OC-768 (40 gigabits per second) optical networks. Feel free to tout the long list of products available at the company's website and SEC filings. You can do it until you're blue in the face, but the bottom line is that all of these initiatives must succeed just to keep Lucent alive, let alone have any kind of growth.
The best Lucent can hope for
In my view, with the Alcatel merger over -- and please don't miss Brian Lund's sidesplitting take on those negotiations -- Lucent is now probably positioning itself for another marriage. After all, it won't have any cash or stock currency left with which to buy, and its mobile wireless and optical networking operations will be too hot and too cheap to pass up -- provided regulators will give it the green light.
But who would be the buyer? Alcatel might want a stripped down, leaner, and meaner Lucent, but it may be the only one. Corning (NYSE: GLW) and Nortel (NYSE: NT) are both ailing, and JDS Uniphase (Nasdaq: JDSU) lacks the stock or cash wherewithal, even if it had any interest in the mobile wireless operations. So split them and sell them separately? Sure, but that makes this stock a speculative short-term bet, with none of the long-term upside I want for my investments.
Bottom line
Lucent has huge revenues, and as several community members note, a small improvement in margins means a lot when you're selling $24 billion worth of products in a year. Innovation will drive telecom market profits for years, and it's true that Lucent has Bell Labs, a renowned research operation. But none of this matters to me. To buy Lucent today is to make a short-term gamble on a buyout at a modest premium, not an investment for long-term market-beating returns.
All risk, no reward. No thanks.
Tom Jacobs (TMF Tom9) believes that hot tubs provide market-beating returns in the winter but not in the summer. At press time, he owned shares of JDS Uniphase. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.
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