Lucent vs. Cisco: Go With the Flow

Two months ago I stirred up some controversy with an article entitled "Cisco vs. Lucent: The Flow Ratio Tells All." In that piece, I claimed that our Foolish Flow Ratio, more than any other analytical metric, tells the story of why Cisco Systems (Nasdaq: CSCO) is a better-run company than Lucent Technologies (NYSE: LU), and thus the better investment. Many retaliated that Lucent should not be judged against Cisco because of inherent business model differences between the two. Well, judge for yourself, but Lucent released its 10-Q on Friday, and its Flow Ratio just keeps getting worse -- along with its stock price.

For those of you not familiar with the Flow Ratio, it's is a simple numeric drawn from a company's balance sheet. It measures the flow of cash through a business, and tells us whether a company is doing a good job of controlling its cash. Why is this so important? Let me put it this way, cash mismanagement is to a business what clogged arteries are to a human -- potentially deadly.

The Flow Ratio is a Rule Maker original, invented by Tom Gardner back in 1997. (I don't know about you, but I remember the original epiphany.) Regular readers here know the Flow Ratio like a dear old friend, but for those of you who are scratching your head over this "Flow" concept, I encourage you to digest this explanation of the Flow Ratio (take your time -- it's time well spent, and we'll wait for ya).

OK, now we all know and understand the Flow Ratio, right? Even so, it never hurts to refamiliarize ourselves with the calculation. So, let's walk through the math behind Lucent's Flow. This is easy stuff -- four numbers, a little subtraction and division, and that's it. The four numbers we need are:

1. Total cash and "near cash"
2. Total current assets
3. Short-term interest-bearing debt
4. Total current liabilities

To find these entries, our next stop is Lucent's balance sheet. This link comes from Lucent's 10-Q, the quarterly SEC filing that is typically released within 30 days after the end of the quarter. You can access these SEC filings from quote.fool.com, but no need to go anywhere right now because, below, I've copied and pasted it for you. Yes, it's pretty long and ugly, but notice that the relevant items are in bold. (I know, I'm way too nice a teacher.)

                                     June 30,
                                       2000
ASSETS ($ millions)

Cash and cash equivalents.........      $710 
Receivables less allowances 
 of $330 at June 30, 2000
 and $318 at September 30, 1999 ..    10,101         
Inventories.......................     4,936
Contracts in process, net of contract
 billings of $6,138 at
 June 30, 2000 and $5,565 at
 September 30, 1999...............     1,758    
Deferred income taxes - net.......     1,511          
Other current assets..............     1,565         
Total current assets..............    20,581
Property, plant and equipment, net
  of accumulated depreciation of
  $6,983 at June 30, 2000 and
  $6,770 at September 30, 1999.....    6,621        
Prepaid pension costs..............    5,923         
Capitalized software dev. costs....      576            
Goodwill and acquired technology, net of
  accumulated amortization of $719 at
  June 30, 2000 and $502 at
  September 30, 1999...............    8,736            
Other assets.......................    3,308
Net assets of discontinued operations    595
TOTAL ASSETS.......................  $46,340

LIABILITIES

Accounts payable............ .....   $ 2,196
Payroll and benefit-related
  liabilities.....................       995
Postretirement and postemployment
  benefit liabilities.............        84
Debt maturing within one year.....     1,321
Other current liabilities.........     3,591
Total current liabilities.........     8,187
Postretirement and postemployment
  benefit liabilities.............     5,346
Long-term debt ...................     3,842
Other liabilities.................     2,835
Total liabilities ................    20,210

SHAREOWNERS' EQUITY

Preferred stock-par value $1.00 per share
 Authorized shares: 250,000,000
 Issued and outstanding shares: none       -
Common stock-par value $.01 per share
 Authorized shares: 10,000,000,000
 Issued and outstanding shares:
 3,339,511,932 at June 30, 2000
 3,142,537,636 at September 30, 1999       33
Additional paid-in capital.........    18,801
Guaranteed ESOP obligation.........       (23)
Retained earnings..................     7,685
Accumulated other comprehensive
 income (loss).....................      (366)
Total shareowners' equity...... ...    26,130
TOTAL LIABILITIES AND
 SHAREOWNERS' EQUITY...............   $46,340

Got those four numbers? Here's where they belong in our list:B

1. Total cash and "near cash" = $710 million
   
2. Total current assets = $20,581 million
   
3. Short-term interest-bearing debt = $1,321 million
   
4. Total current liabilities = $8,187 million
   

Now, we're ready to perform our Flow Ratio calculation. Here's how the math breaks down:

Flow Ratio  =          Current Assets - Cash        
                Current Liabilities - Short-term Debt

            =            20,581  -    710
                          8,187  -  1,321


Flow Ratio  =   2.89

Bad, very bad. We're looking for Flow Ratios below 1.25. From a cash perspective, a Flow Ratio of 1.0 means a company can finance all of its non-cash current assets without any extra cash investment. (Re-read that if necessary.) Lucent isn't even close. A Flow of 2.89 means Lucent is shelling out a lot of extra cash to pay for its current assets, such as inventory and uncollected payments from customers. Quite simply, Lucent's high and rising Flow Ratio is a sign of fiscal waste.

I mentioned "rising Flow Ratio" -- yes, indeed. This marks Lucent's 11th straight quarterly increase in its Flowie. It's been a steady deterioration since late 1997, from a starting Flow of 1.47 all the way up to the current nosebleed (and cash-bleed) level of 2.89. Check out this table comparing Lucent's Flow Ratio track record to that of Cisco:

              Lucent           Cisco
Date       Flow   Stock     Flow   Stock 
12/97      1.47   $22.05    1.44   $10.51
03/98      1.56   $38.01    1.31   $12.21
06/98      1.57   $46.07    1.17   $15.96
09/98      1.69   $40.01    1.13   $18.84
12/98      1.89   $56.19    1.12   $27.89
03/99      2.03   $59.92    1.03   $28.52
06/99      2.18   $65.62    0.87   $31.06
09/99      2.26   $64.19    1.03   $44.59
12/99      2.67   $55.48    0.99   $54.75
03/00      2.80   $62.19    0.87   $69.33
08/04      2.89   $42.38     N/A   $65.56
CHANGE    96.6%    92.2%   -39.6%  523.8%

The disparity in the stock performance of the two companies sums up the importance of the Flow Ratio. Since December 1997, a $1,000 investment in Lucent has become $1,922; in Cisco, your original $1,000 is now $6,238. An eye to the Flow Ratio at any point along the way would've steered you to the better investment.

Tomorrow, Cisco reports its fiscal year 2000 Q4 earnings. Instead of figuring out the whisper number on earnings per share, spend 10 minutes calculating its Flow Ratio using the balance sheet provided in the earnings press release. Compare it to Cisco's Flow of 0.87 in the year-ago quarter and see if the data networking gorilla is still making rules with its usual authority. We'll take a much closer look at Cisco's quarter next week.

In conclusion, Lucent's stock is already down more than 30% since my earlier article, but I still wouldn't touch it with a 10-foot pole. I'll be candid -- at the time of my earlier article in June, several Rule Maker managers were seriously considering Lucent as a short candidate. Only, only if Lucent one day shows progress on getting control of its cash management would I maybe give it investment consideration. Until that day comes, however, I consider Lucent a wait-and-see situation, and perhaps still a candidate for shorting.

Related Links:

Cisco vs. Lucent: The Flow Ratio Tells All, Fool on the Hill, 6/6/00

Lessons From Lucent, Fool Special, 1/13/00

- Matt Richey, TMFVerve on the Discussion Boards