FOOL ON THE HILL
An Investment Opinion
In the early days of my investing education, I laughed off the notion that prospective shareholders should qualitatively rate management performance. It takes some in-depth historical study to pull this off, for one thing, so, like most people, I relied on the standard, easily computed, numerical ratios.
Rationalizing my lack of effort, I convinced myself that a large corporation plows heavily through the business seas like an aircraft carrier, guided mostly by its own momentum and random storms in its product market. Granted, a good skipper can dial in the best long-term coordinates -- set the course -- but they definitely can't steer the bulky ship around sudden hazards. Right?
Given the amazing pace of technology development these days, the ability of management to build a light business model and to steer it adeptly through change is more critical now than ever. Perhaps nobody knows this better than Richard McGinn, CEO of Lucent Technologies (NYSE: LU).
Suddenly, Mr. McGinn finds his ship in a race for the ages with rivals Nortel Networks (NYSE: NT) and Cisco Systems (Nasdaq: CSCO). Seemingly unlimited booty lies open for the taking. But according to the stock market and many pundits, skipper McGinn's recent performance has been less than stellar. In fact, in this piece, three Fools go so far as to say, flat out, that "Lucent's management screwed up." Harsh, dudes.
In light of last week's Lucent earnings release and other developments, let's revisit the two key arguments in this recent mainstream criticism of Lucent management:
1) Lucent Management Has Failed to Adapt Quickly
Of the two accusations, this first one appears to be the more easily supported. Lucent's recent decision to spin off its Enterprise Networks business is an admission, essentially, that the growth side of this market segment now belongs to intranets or, in other words, Cisco.
With $8 billion in annual sales, functioning technology and ages-old customer relationships, the spun-off Lucent business (think office PBX exchange, customer call centers, and the dreaded "if you have a touchtone phone, please press or say 'one' now") will certainly be no joke. In fact, just a few blinks ago it was a white-hot business and it still does a thriving business in the here and now. It's just that its future has cooled, into the merely hot range, and it just doesn't fit, anymore, into Lucent's mega-growth profile. So it had to go.
Yes, the focus of last week's second quarter earnings teleconference was clearly "ongoing Lucent," the two remaining high-growth divisions. And this brings us to the key point: This low-growth end game for the spun-off Enterprise Networks group reflects badly on Lucent management. After all, Lucent products held sway in this market long before the Internet bonanza and the rise of Cisco. It's not like the market stopped growing or Lucent lacks brain power. No way, on both counts. It's just that the market jogged left and Lucent froze, and, just like that, Cisco's intranet-based solutions appear to have gained a stranglehold on the future of this particular market.
Let's turn to the more recent stumble -- allowing Nortel to jump into the lead in optical networks infrastructure and technology. On this issue, Mr. McGinn was refreshingly candid in the earnings call, admitting that Lucent was "late to make the investment" in production and is now in catch-up mode. The world is snapping up every scrap of optical networking equipment as soon as it rolls off the line, and Lucent spent the first quarter trying to get production up to speed. Oops.
2) Lucent Management Has Weighed Down Its Business Model
This accusation of mismanagement may have less merit. It is certainly true that Lucent accounts receivable show a clear upward trend in recent years, and that this is an unwelcome development. But as TMFRunkle shows in this recent article, Nortel is not without its own problems in this regard, as they appear to turn over receivables even less frequently than Lucent!
In fact, this high receivables phenomenon may actually say more about the business of supplying major communications service providers (like ATT, the Baby Bells, etc.) than it does about Lucent's (or Nortel's) management quality. In SEC filings, Lucent makes the point that with a small number of large service providers and the trend toward greater consolidation, these increasingly powerful customers continue to demand that Lucent finance a portion of their receivables, a traditional practice in the industry.
While Mr. McGinn made it clear, in the earnings call, that Lucent is working hard to contain growth in this type of financing (DSO levels dropped slightly during the second quarter), he also affirmed that this type of financing is "part of the business" and that he doesn't expect any dramatic changes, in this regard, in the near future.
Contrary to Lucent's small number of very large customers, Cisco serves a very large count of much smaller organizations who are less able to band together and exert buying power. It's true that Lucent can't touch Cisco's supercharged cash management and this is certainly a defensible rationale for investing in Cisco over Lucent, as the Rule Maker portfolio has chosen to do. But this doesn't necessarily mean that Lucent is being run poorly.
Where I have been critical, above, my goal has not been to bash Lucent. We're not talking about incompetent management at the helm of a dead duck here -- not by a long-shot.
In fact, last week's news includes some positive developments on both of the above-outlined fronts. Lucent's second quarter numbers suggest some impressive strides towards closing the optical networks gap on Nortel. In the conference call, Mr. McGinn claimed greater than 50% revenue growth in Lucent's two highest growth categories -- wireless and Internet infrastructure -- and the near-completion of some major upgrades to production capacity.
A parallel release announces that Lucent will begin outsourcing a big chunk of their low-end manufacturing, which should remove inventory (and some supplier receivables) from Lucent's balance sheet, freeing up cash for expansion. Altogether, these moves should lead to a more nimble and more up-to-date Lucent.
No, the point isn't to bash Lucent. The intended emphasis of the article, rather, is on how difficult it is, nowadays, to steer a large high-tech company. One false move and you can lose a whole business, and Lucent is certainly not unique in this regard. As investors, this can be a frustrating revelation, as management quality is usually the hardest thing to evaluate with any precision. But we skip this effort at our own peril!