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FOOL ON THE HILL
Lessons From Lucent's Cash Flow

Over the past three years, Lucent has reported -- at least until very recently -- healthy and growing pro forma profits. An analysis of the cash flow statement, however, reveals that these rosy reports were masking severely negative free cash flows. Investors should watch closely for similar trends with their own holdings.

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By Whitney Tilson
December 19, 2000

In my columns last week and three weeks ago, I showed -- using telecommunications equipment maker Lucent (NYSE: LU) as an example -- how to break down a cash flow statement by quarter and then make the necessary adjustments to arrive at free cash flow. The main reason I picked Lucent is that it is a good example of how a company can report strong and increasing earnings, yet -- due primarily to a deteriorating balance sheet -- generate large free cash flow deficits.

To get yourself started, take a look at this table. The first line shows Lucent's reported pro forma net income for each quarter from Q1 '98 through Q3 '00, while the second shows free cash flow over the same period:

Lucent                  Q1 98  Q2 98  Q3 98  Q4 98 
Net income (pro forma)   1124    186    518    647 
Free cash flow            173   -499    794   -650  

                        Q1 99  Q2 99  Q3 99  Q4 99 
Net income (pro forma)   1523    533    819    897 
Free cash flow          -1619   -841   -571   -783 

                        Q1 00  Q2 00  Q3 00
Net income (pro forma)   1250    818   1040
Free cash flow          -1019   -671  -1348







*All numbers in millions of dollars.

(See last week's column for details on how free cash flow was calculated. Data from Q4 '00 is excluded because net income is being restated and the cash flow statement has not yet been released. In Q3 '00, Lucent restated its financials due to the spin-off of its Enterprise Networks Group into a separate company, Avaya (NYSE: AV). Consequently, I had to estimate net income and cash flows for Q3 '99, Q4 '99, and Q3 '00. The pro forma net income figures are based on the latest data prior to the spin-off of Avaya.)

Here is what the numbers tell us: Over these 11 quarters, Lucent boasted of "pro forma" profits totaling $9.4 billion, which led the market to award the company a market capitalization of more than $275 billion, among the top 10 in the country (it was also the most widely held stock in America).  But over the same period, Lucent was in fact generating a free cash flow deficit of $7.0 billion. That's a staggering $16.4 billion difference! As I wrote last week, "Revenues (to some extent) and net income (to an increasingly large extent in this market) are opinions, but cash is a fact."

Causes of Lucent's negative cash flow
How could pro forma net income and free cash flow have been so vastly different? In part, it's because Lucent had so many one-time charges due to acquisitions and the like. In 10 of the 11 quarters noted above, Lucent's pro forma net income differed from actual GAAP net income such that actual net income was $6.4 billion versus $9.4 billion of pro forma net income.

In addition, Lucent's capital expenditures rose over this period. The figure varied by quarter, but it was only $234 million in Q1 '98 and was an estimated $713 million in Q3 '00. I subtracted all capital expenditures when I calculated free cash flow, but one could reasonably argue that this penalized Lucent for investing in growth, so if you instead deducted the lower figure for depreciation and amortization, free cash flow would have been $950 million higher. Had you deducted $234 every quarter, free cash flow would have been $3.3 billion higher.

The primary driver of Lucent's dismal free cash flow, however, was a deteriorating balance sheet. From Q4 '97 (as reported at that time) to Q3 '00 (I added Avaya's balance sheet to Lucent's), Lucent's Foolish Flow Ratio soared from a solid 1.36 to a terrible 2.67. Over this period, accounts receivable rose from $5.4 billion to $11.7 billion, consuming $6.3 billion of cash, while inventories rose from $2.9 billion to $5.7 billion, consuming an additional $2.8 billion of cash. Increases in other current assets (other than cash) consumed another $2.2 billion of cash, for a total of $11.3 billion.

Normally, in a growing company, increases in non-cash current assets are offset at least partially by increases in non-debt-related current liabilities. In the case of Lucent, this was true -- just barely -- as non-debt-related current liabilities rose by $0.2 billion. Thus, we can see that an increase in working capital consumed $11.1 billion in cash over this period.

Finally, I have posted some thoughts on the 725% rise in Lucent's shareholders' equity from Q4 '97 to Q3 '00 on the Fool on the Hill discussion board.

Conclusion
My goal here is not to make those who lost money on Lucent feel or appear stupid. I'm aware that hindsight is always 20/20. Rather, it's to help you identify warning flags so you can avoid debacles like this one in the future.

To its credit, the story was well covered by the Fool long before the stock began its precipitous decline. Particularly noteworthy was Lessons From Lucent, which was written on January 13, when Lucent's stock closed at $56.25. How ironic that this column -- one of the best ever on the Fool, in my opinion -- purported to be a "postmortem of Lucent's fall from glory." Lucent's fall was just getting underway.

Given Lucent's obvious weaknesses, I find it shocking that the warnings on this site were not echoed more broadly. Perhaps it's because the deterioration of Lucent's balance sheet and free cash flows -- while alarming in total -- took place gradually over approximately three years. But I think the primary reason was noted in "Lessons From Lucent":

We find it particularly amusing that of the 38 Wise analysts covering Lucent Technologies (as of January 8, there were 15 "strong buy" ratings, 17 "moderate buy" ratings, 6 "hold" ratings, and 0 "sell" ratings on the company), not one pointed out that either the inventory or the receivables for Lucent were skyrocketing. They did not see it or they did not want to see it -- since Lucent represents a very attractive customer of financing business for the investment firms.... It makes one wonder if the analysts are even remotely acquainted with the company's financials.

Finally, as for my opinion on the stock today, I'm sure that a strong argument can be made that the stock is now cheap, but I won't be buying. This quote from "Lessons From Lucent" sums up my feelings:

From our vantage point... there are precious few attractive buying opportunities among the businesses enduring a significant decline in the strength of their balance sheets. Receivables up, inventories up, borrowings up -- this isn't the stuff of quick turnarounds.

If Lucent wants to attract our investment dollars, it will have to get down to the business of cleaning up its balance sheet over the next three quarters. If, instead, the quality of its balance sheet remains at the same level or deteriorates, you can expect the stock price to languish, management to get the boot, and Lucent to find itself losing ground swiftly to the competition.

This recent fall from grace was rapid and harsh -- but only in terms of stock price. The quality of the company's business has been weakening for two years running. Lucent's comeback from here is likely to be slow and is not inevitable. We won't be investing until there are clear signs of a turnaround in the economics, in the fundamentals, of this business.

What amazingly prescient words!

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, click here.



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