Here is the street.com article. This was PM'd me by a couple of friends not interested in being a dartboard today. This is not as bad as I had originally believed it could be.
Cracking the Books II: Lucent's
Growing Fast but Desperate to Keep
Up With the Ciscos
By Alex Berenson and Kevin Petrie
Staff Reporters
10/18/99 11:07 AM ET
They're supposed to be called blue-chips for a reason.
The giants of the Fortune 500 have
long-established brands and billions of
dollars in profits. They have corporate
histories filled with self-love. You might
assume they have no need to push the
limits of accounting rules.
Then there's Lucent (LU:NYSE). The
corporate successor to AT&T's
(T:NYSE) famed Bell Labs will post
more than $35 billion in sales this year,
up from $30 billion in fiscal 1998. Its market capitalization
approaches $200 billion, nearly twice as big as General
Motors' (GM:NYSE) and Ford's (F:NYSE) combined.
Yet some of the telecom-equipment maker's accounting
habits, while legal, are distinctly small-time. Lucent uses a
four-year-old reserve fund to pay some of its bills and has
rejiggered the way it calculates the costs of its pension fund to
cut reported expenses. This year, the gimmicks have helped
Lucent to report record earnings even though its cash flow, or
the amount of money it actually generates from operations,
has turned sharply negative. The big reason for the company's
negative cash flow: Lucent's receivables and inventories have
soared, a sign that the company may be overestimating
underlying demand for its product.
For almost a year, the company has drawn increasing scrutiny
from short-sellers. The Maryland-based Center for Financial
Research and Analysis, an institutional research firm that's
predicted some of the biggest stock blow-ups in the last few
years, has also flagged Lucent as dangerous.
Still, most investors love Lucent. After dropping earlier this
year, the stock has recovered solidly in the last several
months. For the year, it's up 13% and now trades at around 50
times its expected calendar 1999 earnings, twice the multiple
of the average S&P stock. In other words, Lucent is now so
expensively priced that it doesn't have much margin for error.
Now Lucent faces a pivotal earnings report, due out this
month. Its executives have all but promised that the company
will turn in positive cash flow as well as strong earnings for the
quarter ended Sept. 30. And they say that receivables will drop
relative to sales. If they can come through, the shorts will need
to find another expensive tech stock to pick on. If not, Lucent
shareholders could be in for a rough time.
Balancing Act
If Lucent's next 10-Q doesn't show a cleaner balance sheet,
"it's a lot of mud on their face," Sanford C. Bernstein analyst
Paul Sagawa says. Sagawa says some of his institutional
clients are hedging their long positions by shorting shares,
although not on his advice. Still, like most sell-side analysts,
Sagawa thinks the company's underlying growth rates are
good, and he rates the stock a buy. His firm has done no
underwriting for Lucent.
Earnings Are Strong, but Cash Isn't Flowing
Lucent's healthy earnings obscure weakness in cash flow from
operations*
Source: Lucent. Figures in millions of dollars.
*Not EBITDA. Cash flow from operations shows the true measure of cash in
and out of a company's accounts by detailing spending on inventories,
receivables and other items that don't necessarily show up on the income
statement for a particular quarter.
Lehman Brothers analyst Steve Levy is less positive. Levy
rates Lucent a hold and says the company's balance sheet is
signaling that management's growth plan isn't sustainable.
"My sense is that the balance sheet should be telling investors
that there is above-average risk that the company will not be
able to grow as fast as they think," Levy says. "The
fundamental issue is that the company, in my estimation, is
trying to grow too fast." Lehman has no investment-banking
history with Lucent.
One short-seller says Lucent has fallen victim to its own size.
With $30 billion in sales in fiscal 1998, the company will have
to add $13 billion in sales by the end of 2000 just to meet its
target for growth of around 20% annually. By way of
comparison, Cisco (CSCO:Nasdaq), increasingly Lucent's
most important competitor, reported just $12 billion in sales for
fiscal 1999, ended in July. "It's the law of large numbers. You
get to a point where you're so big that the base becomes
unreasonably large," the short says.
Levy doesn't understand the company's lofty ambitions:
"There's nothing wrong with 15% growth when you're a $32
billion company."
But with many investors comparing Lucent to Cisco, whose
revenue has grown tenfold in five years, Lucent's management
may not be in a position to agree.
Shadows and Fog
The questions about Lucent's balance sheet are myriad, but
they fit in two big categories.
First, there are the gimmicks. In the last year, the company
has boosted its reported profits by drawing down a
"restructuring reserve" set up in 1995, changing its pension
accounting and capitalizing its software expenses. With regard
to its pension, Lucent accounted for its fund so that its
balance sheet better reflected the true value of the pension,
whose assets have soared thanks to the two-decade-long bull
market. The move had the effect of giving Lucent a big
one-time boost, along with reducing the company's
contributions to the fund going forward.
There's nothing illegal about Lucent's actions, and they're all
disclosed in its Securities and Exchange Commission
filings. But they combine to boost Lucent's reported
profitability significantly, confusing investors about the
company's true profit from operations.
Collectively, the changes added around $300 million to net
income for the first nine months of Lucent's 1999 fiscal year,
which ended in September. Lucent reported earnings of about
$2.5 billion over the same period, not including a big one-time
gain. Put another way, the gimmicks accounted for almost
one-eighth of Lucent's overall earnings of 80 cents a diluted
share for the first nine months of the year.
Lucent says it has almost exhausted the restructuring reserve,
which was created to smooth the company's breakoff from
AT&T. And the company argues that the change in its pension
calculations will bring its actuarial techniques closer to those
of other big companies.
That explanation doesn't satisfy some investors.
When Lucent unveiled its pension-accounting change in
January, "We were stunned that Wall Street did not question
the credibility of the company," says Daniel McKelvey, money
manager with FC Partners in San Mateo, Calif. While his firm
has owned Lucent since 1996, it has not bought shares in a
year, and McKelvey says accounting questions have prompted
him to consider selling.
"I hope the numbers truly reflect the growth of the company,"
says McKelvey. "I don't want another [type of] pension-plan
number coming in and clouding the numbers." McKelvey says
equity pros are paying closer attention on this quarter: "They're
going to pull back the numbers and scrub them pretty hard.
"Show us the core business line," McKelvey continues. "How
are they producing? It's that simple."
Meanwhile, even as Lucent has grown more dependent on
aggressive accounting to fuel its profits, its balance sheet is
showing strain. The company's inventories and accounts
receivable have soared this year, with inventories up to $5.2
billion in June from $3.3 billion in September 1998, and
accounts receivable rising to $9.5 billion in June -- more than
the company's sales for the quarter -- from $7.4 billion in
September 1998.
Lucent Lags Behind
Revenue growth at Cisco and Lucent,1996-99.
Source: Company documents. FY99 data for Lucent projected
At the same time, inventory turns, or the number of times on
average that Lucent sells its inventory each quarter, have
dropped dramatically, to 4 in June 1999 from 5.6 in June 1998,
according to Levy, the Lehman analyst. Every one of Lucent's
big rivals, from Cisco to Nortel (NT:NYSE) to Nokia
(NOK:NYSE ADR), does a better job of managing its
inventory.
"Finished-goods inventory to me is really what's a problem,"
Levy says. "Typically, you do not want to build product before
you're ready to ship it, because when you finish a product and
don't ship it, you've spent money. ... You want to do that in the
quarter that you recognize revenues."
The rise in receivables, or bills that Lucent's customers haven't
paid yet, is also worrisome. Lucent skeptics contend that the
company is encouraging telecom carriers to buy more
equipment than they need, sometimes by offering to give them
extra time to pay. Additionally, the company sometimes
finances its sales, although it refuses to disclose exactly how
often.
Lucent says the rise in receivables is mostly related to the
growth in its international business. But Levy disagrees, noting
that the growth in receivables far outpaces the rise in Lucent's
international sales. "We do know that they're being very
aggressive, and there are sales promotions at the end of the
quarter," Levy says.
Other analysts caution against reading too much into Lucent's
receivables. Phone companies "dance" around their bills for as
long as possible before paying them, according to Sagawa,
who worked as a salesman for Lucent when it was still a
division of AT&T.
Managing Expectations
Can Lucent put the shine back on its balance sheet? Levy
thinks so, but he says the company has to accept slower
growth -- and be honest with investors about what to expect. "I
think it's already started to show," he says. The company has
tried to guide analysts' expectations down "just a hair" for the
current quarter as well as for the December quarter, he says.
Of course, Lucent could also keep squeezing its balance
sheet to buy time until its problems are too big to be hidden,
then preannounce an earnings shortfall and watch its stock
crater. But a blue-chip company would never do that, would it? |
