Lessons From Lucent
A Motley Fool Special Report

By Matt Richey, Bill Mann, and Tom Gardner

(Jan. 13, 2000) -- Often, the best investing lessons are learned in darker hours. In this postmortem of Lucent's fall from glory, we'll seek to answer the following four questions:

  • What does Lucent do?
  • What just happened to Lucent?
  • How could you have seen it coming?
  • Where to from here?

Lucent Technologies (NYSE: LU) has been an investor favorite during its 892% run since being spun off by AT&T (NYSE: T) in April 1996. A market-beating performance like that naturally wins over a lot of fans. And, in fact, Lucent is America's most widely held stock. Against that backdrop of almost universal popularity, the company's earnings warning last week came as an utter shock to many in the investing world. Perhaps you are one of the millions blindsided by the news and the subsequent hit to the stock. It was a hit that subtracted more than $80 billion from Lucent's capitalization.

In a sense, the news was shocking, as Lucent's 15-quarter streak of beating Wall Street's earnings estimates will come to an abrupt end. But to those investors who make a habit of ignoring the pundits, and instead focus on the business fundamentals, Lucent's blowup wasn't the least bit surprising. In fact, we've been sharing some of our anxiety about Lucent in the Rule Maker Portfolio and on The Motley Fool Radio Show for months.

From whence came that concern? Were we magicians or gurus? Or did fluttering red flags appear to those who love only simple mathematics? Let's explore....

I. What does Lucent do?

You know the answer to this one -- all together now, "Lucent makes the things that make communications work." Not a bad plain-language description, but let's dive a little deeper.

Lucent is the former Bell Laboratories, the research and development arm of AT&T that has spawned such telecommunications technologies as the T-1 circuit, digital signaling, and the Private Branch Exchange (PBX), upon which the majority of office telecommunications environments are currently run.

It's safe to say that Lucent has its hand in almost every honey pot of the telecom world, but its specialty is in old-world circuit-switched voice networks, the stuff of its heritage with Ma Bell pre-1996. The bulk (65%) of Lucent's revenues come from providing switching, network, and operational equipment to the service provider segment, including major information providers such as telecommunication carriers, Internet service providers (ISPs), cable companies, and wireless communication providers.

All in all, Lucent holds 11% of the worldwide service provider equipment market, a market expected to be worth nearly $500 billion annually by 2003. Some of these service provider customers, such as AT&T and the Baby Bells, have been working with Lucent for years in building voice networks.

But with the advent of the Internet, data traffic in the form of Internet protocol (IP) is gaining prominence and growing much faster than voice traffic. And as data and the Internet gain ground, so wanes the competitive advantage of Lucent's core competency. Lucent is seeing this convergence of voice, data, and Internet eat into its incumbent market as voice is only one component part of the new generation of networks.

In addition to that, wireless is gnawing away at Lucent's traditional voice market. Using cellular, microwave, and radio waves, the wireless companies are providing the "local loop" to retail customers of telecommunications services, an area in which Lucent badly trails its competitors.

II. What just happened to Lucent?

On Jan. 6, Lucent issued a press release stating that its fiscal first-quarter results would fall well short of expectations. How far short? Compared to the year-ago numbers, Lucent now says that revenues will be flat and earnings will actually decline 20%. Historically, Lucent's fiscal first quarter has been its strongest due to the buying habits of its service provider customers. Not this year.

To put it simply, Lucent's management screwed up. They mis-executed on a number of fronts, including manufacturing bugaboos and being out of touch with their customers' technology needs. Whether Lucent's management was focusing on short-term incentives or whether they simply lost control over a business beset by competition on every side is open for debate. What is certain is that Lucent's business had been weakening -- as we will consider in a moment -- for some time. This announcement was merely a continuation of a string of troubles in the company's core business.

III. How could you have seen this coming?

You may be surprised to learn that predicting Lucent's fall had nothing to do with your ability to understand optical networking, OC-192 fiber, dense wavelength division multiplexing, and other hard-to-define tech lingo. While there are some significant technological challenges for Lucent to overcome in the future, they had little or no effect on the earnings shortfall. Rather, Lucent's undoing was plainly foretold in its quarterly financial statements, available for all the world to see. And you only needed to understand one simple principle of financial analysis to see this coming -- namely, that growth in inventory and accounts receivable should be no faster than growth in sales.

Let us explain.

Inventory is stuff that a company hasn't yet sold but expects to sell. Be leery, friend, because inventory sits in expensive warehouses, depreciating in value. Inventory is listed as an asset on the balance sheet but, in this regard, be contrary, Fool. For all practical purposes, it's a costly liability. The ultimate goal for a manufacturer such as Lucent should be to produce inventory on a just-in-time basis so that the product goes straight off the assembly line and into the customer's hands. Unfortunately, that wasn't happening. Too much Lucent equipment was sitting unsold.

Like inventory, receivables are another balance sheet item. They're listed as an asset, but they're really a liability in disguise. Receivables are a company's uncollected revenues. Here's an example: If Lucent ships a switch to AT&T, and AT&T promises to pay in 60 days, then that promise represents a receivable from AT&T. In this scenario, AT&T gets the product but doesn't have to pay for it immediately. This is not good business for Lucent. These receivables represent a sale that has been announced and recorded on the income statement -- but a sale for which cash has not yet been received. That makes the income statement look good (keeping Wall Street happy) but wreaks havoc on the balance sheet (destroying the faith of long-term investors). You cannot pay your employees with a receivable. You cannot invest in new technology with a receivable.

The fact is that accounts receivable are a liability until cash payment is received. The darker side of this is that some mischievous companies can misuse them and extend very "loose" receivables terms ("buy now, with no payments 'til 2001") in order to deceptively boost current sales. This can particularly be a problem at a company that rewards its management and its sales force according to "booked sales" rather than "collected sales." The team can grow so obsessed with closing deals quickly -- to hit their incentives -- that they sign unfavorable terms to get them signed.

Thankfully, there are a few easy ways to check against the misuse of receivables and inventory. The simplest rule of thumb is that neither of those items should grow faster than sales on a year-over-year basis. For Lucent, however, the numbers have broken this rule in each of the past four quarters:

                     Q4 '99    Q3 '99    Q2 '99    Q1 '99
 Sales Growth          23%       22%       33%       6%
 Inventory Growth      54%       74%       51%      45%
 Receivables Growth    41%       64%       57%      46%

Danger, Will Robinson. You are casting your eyes on a hideous four-quarter performance. Receivables and inventories have vastly outpaced sales throughout the past year. Is it any wonder that trouble loomed ahead?

When you encounter a situation like this, where receivables and inventories are zooming ahead of sales, let that set off alarms in your mind, Fool. You'll want to probe and find out if management has a plausible explanation for such events. Even then, be skeptical. The numbers tend to be much more revealing than press releases.

In Lucent's case, the numbers have been out of whack for as many as eight consecutive quarters, and there never has been any justification from management. That should send you to the exits. It's the primary reason that the Fool's Rule Maker Portfolio owns no shares of Lucent, preferring instead to own its efficiently run competitor, Cisco Systems (Nasdaq: CSCO).

Now keep in mind, dear Fool, that the information above did not require any heavy lifting, trigonometry, nary even a slide rule. It's a simple equation available to simple minds (like ours).

Given that, 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. One analyst, Steve Levy from Lehman Brothers, put out a higher price target the same day that Lucent announced it was lowering its earnings targets. It makes one wonder if the analysts are even remotely acquainted with the company's financials.

Just as interesting, not even Lucent is really fessing up to this yet. The company has pointed to its "inability to meet current demand" as the primary reason for its shortfall in earnings this quarter. We disagree. This does not appear to be a case of supply being outstripped by demand. Rather the company's own demand to get deals signed too quickly appears to be outstripping the qualities of patience and smart business. All in all, not only did Lucent fail to manage its cash position to the detriment of its current shareholders, but also the analysts, whose job it is to serve as watchdogs for just these types of financial deterioration, did not notice or chose to ignore this problem.

IV. Where to from here?

At present, most voice, video, and data traffic travel on separate networks. But demand for the Internet is driving service providers and large business enterprises to look for ways to integrate it all into one package. They are trying to put voice, video, and data networks into a single multiservice network.

For these new-age networks, service providers are spending big bucks, as in hundreds of billions of dollars annually. Lucent itself estimates this convergence market to be an $815 billion opportunity by 2003. And all of this money is being spent to provide a broader range of services (high-speed Internet, video on demand, etc.) at a lower cost.

On one hand, Lucent wants to benefit from this bonanza of spending. It sees the future. But on the other hand, Lucent wants to protect its old-line circuit-switching networks. It has enjoyed its lucrative voice network revenues for a long time. Network integration may well mean a loosening of Lucent's grasp on the voice business.

Unfortunately, Lucent's problems won't be solved easily. The sky-high receivables and inventory growth demonstrate that management has been willing to resort to financial gimmickry in order to satiate Wall Street's earnings demands. Unless management changes its ways and gets its financial house in order, Lucent will continue to suffer. And we, as long-term investors, will continue to look to other businesses with our investment money.

On the plus side, Lucent's research facility is considered within the industry to be unparalleled. In fact, Lucent controls more patents than any other single company on the planet. However, given the rapid migration toward fully integrated data-capable networks, even without the financial problems, Lucent will be hard-pressed to maintain its preeminence in the industry.

To top it all off, Lucent has assumed a significant amount of debt in the wake of a stream of acquisitions (including that of Ascend Communications). Today Lucent carries more than $4 billion in long-term debt, alongside $1.8 billion in cash. Those aren't horrible numbers, but they don't represent the sort of underlying financial resources we like to see among companies valued in excess of $150 billion.

In situations like this one, we often see the embodiment of the old adage that there is no price low enough for a bear, none too high for a bull. For every investor declaring Lucent dead meat, there is another saying that this price drop is a significant buying opportunity.

From our vantage point, though, 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.