The Rest of the Lucent Lesson

Occasionally, we look back on some of the best columns of the Fool's first decade. Today, we continue our look at 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 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.

In yesterday's column, we examined what Lucent (NYSE:LU) does and what happened to cause investors to shave 28% off its market cap. Today we'll continue explaining how you could have seen this coming -- and hopefully how to avoid such disasters in the future.

First, let's reiterate the company's receivables and inventory situation. 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:

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 Jan. 8, 2000, 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 even 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, it 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, borrowing 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.

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