Tuesday, April 14, 1998

Cash-King Portfolio Report
Al Levit

Glendale, CA (Apr. 14, 1998) -- Every once in a while, a great company's stock just drops into your lap. Literally. That's what happened to Jeff and Dave over in the Fool Portfolio. And it happened to me. And I dare say it probably happened to many of you reading this column right now.

The stock? Lucent Technologies (NYSE: LU). Many of us acquired it through no fault (or analysis) of our own when Foolish Four holding AT&T (NYSE: T) spun it off on October 1, 1996. Since that time, both Lucent and AT&T have been pronounced market outperformers.

But is too much of a good thing a problem?

Lucent presented the Fool Portfolio and the rest of us lucky shareholders with a very nice challenge. As a Dow Dividend spin-off, the standard rule is that the stock should be sold at the 18-month-and-a-day turning point. But just before the appointed sale, we then had the good fortune to platter-smash the Magic Gong because Lucent had officially doubled in price. That was interesting, because around Fooldom, we're frequently schooled to let our winners run. And here was a business that was winning, but the mechanical model was advising us to sell.

Mixed messages. What to do?

As I wrote a few weeks ago, in a situation like this, my first thought is always to see if Lucent is a Cash-King. A quick trip to Edgar online led me to Lucent's 10-Q report for the quarter ending December 31, 1997. It was time to do some checking up. But before we look closely at the numbers, let's take a cursory look at Lucent's business.

Lucent used to be known as Bell Labs, a well-known brand name subsidiary of AT&T. The company makes a variety of telephone equipment. Currently, about 68% of its revenue comes through sales of systems for network operators, up from 63% in the previous year. The next largest segment of its sales is from business communications systems. Both of these are strong growth industries, so future prospects look strong.

The key risks to Lucent's business come from its customers. Its incoming orders are seasonal, and, according to the 10-Q, historically Lucent has been forced to rely on a limited number of customers for a substantial portion of total revenues. Further, many of its orders are delayed until the final quarter of the calendar year.

Lucent has managed this risk by changing its fiscal year and its employee compensation programs. But, on the qualitative side, the nature of Lucent's customers really has me questioning whether this is a Cash-King. After all, we're looking for mass-market consumer brand names. With a limited number of customers paying a lot of money, Lucent is exposed to the risk of a given customer backing off in a bad economy or jumping ship to a competitor. That makes me anxious.

But let's look at the numbers. Lucent certainly passes most of our tests:

Market Capitalization (> $5 billion): $78 billion 
   Gross Profit Margin (> 50%): 48% 
 Avg.Net Profit Margin (> 7%): 9.1% 
     Cash as % of Debt (> 150 %): 63% 
            Flow Ratio (< 1.25): 1.21 
       Cash on Books: $1.2 billion 
  5-Year Growth Rate: 20.0% per year 

The biggest numerical concern is the debt. Lucent's long-term debt at the end of 1997 was $1.9 billion, up from $1.7 billion in the previous quarter. This increase came from the company's decision to issue $300 million worth of 30-year bonds while reclassifying some short-term debt as long-term debt. The company maintains another $5 billion in credit facilities to give it room to issue more debt in the future.

In previous quarters, Lucent's debt has stayed fairly constant. Its interest expense remained at the same level in the current quarter -- $79 million -- as in the previous quarter. I see no indication that Lucent is going to move to reduce its debt in the foreseeable future. It has obviously made the decision to over-invest into great opportunity, and certainly this approach can work. And while we're not as attracted to businesses that have to take on debt to accelerate their growth, we understand it.

Ok, after this brief review, I find three areas in which Lucent doesn't meet our Cash-King criteria:

1) Gross margins are a tad under our 50% standard.
2) Debt levels are too high.
3) The company has a limited number of very large customers.

My responses to the following are that the gross margins shortcoming is a trifle and the debt levels are bearable since Lucent is well-capitalized with over $1 billion in cash. Those are fine. But this matter of a limited number of customers is a problem for me.

Ideally, our Cash-Kings sell directly to consumers (e.g. Coke) -- ideally billions of them. And for those that, instead, sell to businesses, we look for the ones that market through to consumers (e.g. Intel). A third example would be Pfizer, which neither sells nor markets through to consumers, but is very well know among a very large number of purchasers of its products, the physicians. Also, the consumers of its products are usually very aware that they're using Pfizer drugs.

Unfortunately, Lucent doesn't really fit any of these models. Instead, the company sells product to a limited number of customers in a seasonal business that is out of view of the average consumer. Right now, for instance, Lucent cannot call on mass-market consumer demand and adoration to support rising prices and to protect itself in economic downturns.

The company is well aware of the problem and is doing what it can to manage away that risk. Also, let's face it, Lucent did extremely well in its big December 1997 quarter. It announced $8.7 billion in sales with over 9% margins -- a blowout of expectations. We've seen how well the stock performs in a great quarter. But what would happen in a slowdown with a few large partners?

Now, I could probably be persuaded that Lucent is a Cash-King in spite of any one of the three items above. I've pretty much convinced myself out of being worried about the first two. But that third consideration has me on edge. For this reason, I don't think Lucent fits our model, even though it's a great company with plenty of opportunity ahead of it. Thus, I hereby declare Lucent great, but not a Cash-King.

I can be convinced otherwise. If you'd like to try, drop by the Cash-King message folder.

I'll be back tomorrow with Q&A from the message boards. Have a great evening,



Stock  Change    Bid 
 CHV     ---    78.88 
 KO    +  5/16  77.88 
 EK    +3 13/16 70.81 
 XON   -  9/16  67.13 
 GM    +2 5/16  69.88 
 INTC  -  1/4   76.00 
 MSFT  -  3/16  88.44 
 PFE   -1 15/16 99.06 
 TROW  -  5/8   72.75 
                  Day   Month    Year  History 
         C-K      +0.20%   0.58%   4.55%   4.55% 
         S&P:     +0.55%   1.27%  11.43%  11.43% 
         NASDAQ:  +0.99%   0.40%  11.50%  11.50% 
     Rec'd    #  Security     In At       Now    Change 
    2/3/98    22 Pfizer        82.30     99.06    20.37% 
    2/3/98    24 Microsoft     78.27     88.44    12.99% 
    2/27/98   27 Coca-Cola     69.11     77.88    12.69% 
    3/12/98   20 Eastman Ko    63.15     70.81    12.14% 
    2/6/98    28 T. Rowe Pr    67.35     72.75     8.02% 
    3/12/98   20 Exxon         64.34     67.13     4.34% 
    3/12/98   17 General Mo    72.41     69.88    -3.49% 
    3/12/98   15 Chevron       83.34     78.88    -5.36% 
    2/13/98   22 Intel         84.67     76.00   -10.24% 
     Rec'd    #  Security     In At     Value    Change 
    2/3/98    22 Pfizer      1810.58   2179.38   $368.80 
    2/3/98    24 Microsoft   1878.45   2122.50   $244.05 
    2/27/98   27 Coca-Cola   1865.89   2102.63   $236.74 
    3/12/98   20 Eastman Ko  1262.95   1416.25   $153.30 
    2/6/98    28 T. Rowe Pr  1885.70   2037.00   $151.30 
    3/12/98   20 Exxon       1286.70   1342.50    $55.80 
    3/12/98   17 General Mo  1230.89   1187.88   -$43.02 
    3/12/98   15 Chevron     1250.14   1183.13   -$67.02 
    2/13/98   22 Intel       1862.83   1672.00  -$190.83 
                               CASH   $5666.26 
                              TOTAL  $20909.51 
 *The year for the S&P and Nasdaq will be as of 02/03/98