Occasionally, we look back on some of the best columns of the Fool's first decade. Today, we revisit the tale of Lucent and the lessons of its fall. The Fool has always sought to teach investors to pay attention to and understand basic company financials. Perhaps nowhere did this knowledge pay off more than with Lucent, which in 2000 was America's most widely held public company.

All through 1999, Lucent's balance sheet had deteriorated -- and quite obviously. One week after a Jan. 6, 2000, earnings shortfall and a one-day 28% plunge, we published a special report on what exactly happened. Authors Tom Gardner, Bill Mann, and Matt Richey concluded that Lucent's initial sell-off was likely the beginning of what would be a painful investor odyssey with a far-from-certain ending.

On the day the report was published, Lucent closed at $56.21. Even then, clues that Lucent might eventually fall to pennies were there to see. After a brief run-up, the stock plunged. Today, nearly seven years later, the stock is still more than 90% off its early 2000 levels.

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:

1. What does Lucent do?

2. What just happened to Lucent?

3. How could you have seen it coming?

4. 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 Baby Bells like BellSouth (NYSE:BLS) and Qwest (NYSE:Q), 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, 2000, 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 grant 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?

Tomorrow, in the second and final part of this teaching series, we'll dig a little deeper into Lucent's situation and find out what made Tom, Bill, and Matt warn Fools away from this stock in early 2000.

Tom and Bill combine their brainpower as co-analysts for Motley Fool Hidden Gems . Their recommendations have average gains of 43%, vs. 18% for equal investments in the S&P 500. Here's more information on a free trial.