FOOL ON THE HILL
An Investment Opinion
Why Lucent's Fall Matters, Sort Of Bill Mann (TMF Otter)
January 7, 2000
The Nasdaq Composite Index did a tremendous about face this week, starting the week (and the year) shooting up to an all time high, and then spending the next three days in an absolute free-fall. On Tuesday the composite lost a record 229 points, which was the second-greatest percentage loss (5.5%) in the history of the index. It then followed up with additional losses of 0.62% and 3.88%. As I write, the Nasdaq is up today, though it is likely to end the week lower by 7%+ than it started. This rollback eliminates more than 10 days worth of gains from last year. Hardly a reason to get one's pulse racing, right?
In other words, to the long-term Foolish investor, this, as well as the gains from the last week, were non-events. David Gardner and Jeff Fischer had an interesting back and forth this week in the Rule Breaker portfolio. Jeff Foolishly decided not to even mention that the Rule Breaker went up 11% on Monday, viewing it as a non-event in the total scheme of things.
For those of you who follow the RB, on Monday it gained nearly $100,000, not bad for a single day. Now, we're not robots, so even the most committed long-term, buy- and-hold advocate tends to look at a day like that and giggle a little bit. And thus, on Tuesday, David Gardner did a very prudent thing. He commended Jeff for his level-headed approach to the gains the previous day, and then he took the same even-handed approach to the shellacking the BreakerPort took on Tuesday.
It was a great follow-up, and to me it re-emphasized the old adage that the market is a popularity contest in the short run, a scale in the long run. David and Jeff both know the companies they hold very well. This allowed them to see the surge on Monday as well as the hammering on Tuesday for the illogical, non-fundamental events that they were. Kudos to the two of you, and to everyone else out there who has watched the manic-depressive swings in the Market and yawned.
But there are a few events from the past week that are real, and should be reviewed for their effect on the investors in the specific companies involved as well as the others like them. First, overnight on Wednesday, the president of NOW 50 component Sony Corporation (NYSE: SNE) Nobuyuki Idei cautioned investors that the levels to which they had bid his stock were unrealistic given the projected revenue streams of the company.
There are a couple of very admirable things that we should take from this. First is the fact that Idei made this comment not to analysts behind closed doors, but to the public, so that each investor got the same information at the same time. This is particularly noteworthy because Sony, as a Japanese company, is not beholden to the selective disclosure laws of the United States, and by dint of Japanese law has a lower incentive level to guide all investors at the same time. So although the current shareholders of Sony are unlikely to be ecstatic about the comments or the effect upon Sony's shares as a result (down nearly 15% yesterday), they should take some comfort that the way in which Idei made his statement was very, very shareholder-friendly.
In addition, Idei's comments should have a long-term positive effect, based upon his recognition of the irrational behavior of the market. He's helped let some of the air out of the bubble he saw forming in his company's share price. And if there is one thing that the Japanese should have an understanding of far beyond our own, it is the damaging effect a bubble can have on all facets of an economy.
But the goings on at Sony is not the biggest of the week, nor are they the ones that will have the widest effect on the American stock market. That honor goes to another NOW 50 company, Lucent Technologies (NYSE: LU), which yesterday stated that its revenues for the first quarter will be flat and its earnings will be below expectations by more than 40%, 25% below operational margins from a year ago. This will mark the first time that Lucent will not meet earnings expectations since it was spun off from AT&T (NYSE: T) in 1996. Lucent's lowering of expectations for this next quarter sent its share price spiraling downward by more than 24% yesterday, dragging many of its high-flying telecommunications brethren with it.
Lucent is, by market capitalization, the second-largest telecommunications company in the world, after Japan's NTT (NYSE: NTT). Moreover, Lucent is looked upon, rightly or wrongly, as a bellwether for the telecommunications equipment companies. So when Lucent sneezed yesterday, everyone playing on its block caught its cold. In general, this is an appropriate reaction. If the largest, most influential company has economic pressures, it goes to figure that the entire sector could be in for the same worsening of condition. In particular, when a group of companies have been awarded such high multiples on current earnings, a worsening of projections probably should be accompanied by a reduction in that multiple. But in this case, the hit that such competitors as Alcatel (NYSE: ALA) and Nokia (NYSE: NOK) took yesterday were overblown and inappropriate, because Lucent's wounds are self-inflicted.
A brief look at Lucent's balance sheet shows a few chinks in the armor, ones that should have been pretty visible to investors during their due diligence. The company's long-term debt level of $2.5 billion is relatively high, but sustainable. Where Lucent gets low marks is in its cash and asset management. The company's receivables and inventory loads increased significantly over the last four quarters, which meant that the company was counting sales before they happened.
In accordance with GAAP (Generally Accepted Accounting Principles) accrual methodology, companies may book accounts receivable as current sales rather than waiting for the cash to actually come in. In Lucent's case, both the level of receivables and the average lag time for payment of those receivables were ballooning. This is a cash drag on the company, as it lets the cash sit in some other company's bank account. For a company with the market weight of Lucent, poor performance for accounts receivable shows a lack of attention, since the company should by all measures be able to be strict in its terms to its customers.
Today the impression is that it will take Lucent longer than one quarter to get things cleaned up. This is a company that has back-end loaded its revenues for several quarters, a vicious cycle that when broken tends to uncover other frailties when it pops. Still, the fact that Lucent points to its inability to meet certain demand for its products shows that the overall health of the telecommunications sector is still strong, and that other equipment providers should not be punished for the transgressions and operational errors of Lucent. In particular, this may turn out to be a boon for the largest competitors for Lucent in the data and telephony markets: Cisco (Nasdaq: CSCO) and Nortel Networks (NYSE: NT), as they could now have a perceived operational advantage over their huge rival.