February 9, 1999

Stocks Fools Love

Lucent Technologies
by Paul Motter (TMF DotCom)

Trading at 100 11/16 as of February 8, 1999

When I recommended Lucent Technologies (NYSE: LU) as my Stock to Love last Valentine's Day, the stock was trading at $41 11/16 per share, adjusted for the split that occurred last April. By mid-July it was a double. Can Lucent do it again? Let's take a look at the issues facing the company this year.

Lucent has topped earnings estimates every quarter since its October 1996 spin-off from AT&T (NYSE: T). This includes the recently completed quarter, where earnings came in at $1.05 per share vs. estimates of $1.01. Some investors believed the report showed slowing revenue growth, and the stock suffered a small selloff. But the company responded that the lower revenue figure was due to a reporting delay for a portion of income that will be added to the next quarter. Demand for the company's products is as robust as ever, according to the company and analysts.

Significant in the earnings report was the announcement that profits were boosted by strong demand for its data networking equipment and better-than-expected foreign sales. News of robust foreign sales is encouraging, considering economic conditions overseas. But strong demand for data networking equipment is the most telling indicator.

First quarter gross margins were 52.3%, up from 48.2% in the year-ago quarter, due to a strong mix of more lucrative products (data networking) and reduced costs. Lucent CEO Rich McGinn stated that Lucent expects gross margins for the second quarter and fiscal year to be in the high 40% range, but added that Ascend and another acquisition, Kenan Systems, could further boost margins.

Lucent is already a major contender in voice networks and a growing participant in the datacom business. With the Ascend acquisition (still subject to shareholder approval), Lucent is about to significantly deepen its bench.

Benefits of the Ascend Acquisition

An important statistic to understand in the communications business is that voice communications is currently a significantly larger business than data, but data is growing at a much faster rate. As a prominent data networking equipment vendor, Ascend already has the inside track for selling to service providers of Internet and other data connectivity, while Lucent commands a significant share of the voice communications products market. The merger creates a communications powerhouse with the potential for Lucent to crossover and sell voice systems to Ascend's data customers and expand its data systems sales to current customers.

Future Potential

Ascend recently acquired Stratus Computer Systems, a maker of high-end computer products for the telecom industry. Central to the Stratus product line is its version of the SS7 protocol used to control messaging in voice systems. Ascend's goal is to incorporate the SS7 protocol into its data connectivity hardware and further the ability to send voice over data networks. The Stratus acquisition was the icing on the cake, making Ascend an attractive target for Lucent. Lucent, already a specialist in voice systems, now has the technological edge to lead the charge towards the next generation of voice/data convergence products.

Assimilation Issues

Ascend is a true Silicon Valley success story and, like most Silicon Valley companies, it has a culture that rewards engineering expertise with rapid promotion and stock options. Lucent, on the other hand, is a traditional East Coast telecom company, where advancement is slower and compensation is doled out at a predetermined pace.

A lot of questions have been raised, many of them by Lucent competitors, as to whether Lucent can convince the engineering talent at Ascend to remain with the company instead of fleeing to the aggressive Silicon Valley companies who will try to lure them away. According to (Lucent competitor) Alcatel Chairman Serge Tchuruk, when the acquisition is finalized Lucent will be paying a much higher acquisition cost than normal for each Ascend engineer -- $15 million per engineer vs. the $3-4 million standard in the telecom world.

Will Lucent be willing to protect its investment by ensuring that the engineers remain? I believe it will. One of the most promising aspects of another recent telecom/datacom merger, Nortel's acquisition of Bay Networks, was the immediate steps the company took to reassure Bay's engineers that it is worth their while to remain at their jobs. I believe Lucent will follow Bay's example.

Furthermore, even though many large technology mergers involving cultural disparities had assimilation issues that were never fully resolved -- 3Com/U.S. Robotics and WellFleet/Synoptics being examples -- some companies have a track record of successful mergers. Ascend's acquisition of Cascade Communications in 1997 is one example. Cascade/Ascend managed to overcome the initial philosophical differences and proved itself a winner, and I believe that Ascend can do it again with Lucent.

Significant to that belief, the Cascade branch of Ascend is still situated in Massachusetts, a few hours away from Lucent headquarters in New Jersey and, although Ascend's West Coast arm of edge devices is important to Lucent, the jewel of the deal is the former Cascade's brainpower for ATM and frame-relay switching. Cascade, I believe, will dovetail nicely with Lucent's methods.

So, I am recommending Lucent once again as the stock I love. Near term, it may suffer some growing pains as merger issues are ironed out and the inevitable Y2K uncertainty prevails but, as a buy-and-hold candidate, Lucent is my Valentine.

Lucent Company Information:
Trades on the NYSE under symbol LU
Web Site: www.lucent.com

Company Address:
600 Mountain Avenue
Murray Hill, NJ 07974

Other Related Links:
Current Quote
Message Board
Lucent to Acquire Ascend -- 1/13/99
Lucent Q3 1998 Conference Call Synopsis
Daily Double -- 7/13/98

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