Mr Fun,
Here's a little ditty that perhaps you and Chuzz can chew on. As I mentioned before "meeting demand" is/was not the issue. It was collecting on shipments. This I believe is represented as either inventory or receivables dependent upon customer acceptance (as you pointed out). Problem is this is a big bubble on the balance sheet and will forever cause problems for LU. This accounting practice will not allow them to compete in this fast paced market and this really needs to change. One other point is that the shortfall has very little to do with meeting demand for OC192. I truly believe now that circuit switch sales are being propped up by finance deals...and that appears to even not be enough. Let's face it, $2B (20%) shortfall in revenues is not all related to OC192 and software.
fool.com
Lessons From Lucent
A Motley Fool Special Report
By Matt Richey, Bill Mann, and Tom Gardner
(Jan. 13, 2000) -- 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:
What does Lucent do?
What just happened to Lucent?
How could you have seen it coming?
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 the Baby Bells, 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, 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 sign 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?
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 January 8, 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, Steve Levy from Lehman Brothers, 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, Lucent 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, borrowings 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.
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