LU Discussion:
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Thanks again TM for this email!
TMF Interview With Fools Paul Commins, Bill Mann, and Matt Richey
Lucent Roundtable
With Chris Rugaber (TMF RFK)
August 10, 2000
Telecommunications equipment giant Lucent (NYSE: LU), is a company at a crossroads as it plans to split up its three core divisions. Fools Paul Commins (TMF Buster), Bill Mann (TMF Otter), and Matt Richey (TMF Verve) recently sat down with moderator Chris Rugaber (TMF RFK) to discuss the state of things at the AT&T (NYSE: T) spin-off in terms of the company's business, competitive position, and financial condition.
TMF RFK: Thanks for joining me on this chat today. We're discussing Lucent, the largest telecom equipment maker out there. Would one of you like to describe their business, in general terms? How about it, Bill Mann?
TMF Otter: Lucent is the spin off from AT&T. It is basically their development and equipment arm. Their business is really in three broadly defined areas, optical networking, PBX systems, and telecommunications switching.
TMFBuster: The company has announced plans to split up along its three core divisions. The old office switching piece is to be spun off, the microelectronics and components group will be spun off also, and what's left over -- the optical networking piece -- will be the new Lucent.
TMF RFK: Well, that sounds like a pretty impressive industry. So why is the stock down over 35% so far this year?
People have been counting on optical networking to pick up the slack, but Lucent's projected 15% growth just won't cut it.
TMF Verve: Basically, the-most recent earnings release states that the company dropped the ball in the midst of product transitions. The old circuit switching business is screeching to a halt and the new optical biz isn't up to speed yet, so revenue growth has ground to a halt. Even looking at the "new Lucent," management only expects 20% top-line growth. That isn't much considering that Cisco (Nasdaq: CSCO) is still predicting growth of 30-50% annually and Cisco isn't much smaller than Lucent anymore. Cisco's most recent quarterly revenues reached $4.9 billion. That's only 40% less than Lucent's quarterly sum.
TMFBuster: Can we pinpoint precisely where Lucent "dropped the ball"? Is it in providing networking equipment to the telecommunications companies or is it in providing the components needed to build the networks?
TMF Otter: I can do that. Lucent screwed up in 1998 when it delayed developing its 10 gbps (gigabits per second) systems for optical switches. The company that has been eating Lucent's lunch is Nortel (NYSE: NT), which did not delay in 1998, pushed ahead with the 10 gbps multiplexers, and has been ahead of Lucent in this area ever since. Nortel also has all of its optical components produced in house, while Lucent depends heavily on JDS Uniphase (Nasdaq: JDSU) for its components, which hurts its gross margins.
TMF Buster: By spinning off its enterprise networking division, isn't Lucent essentially giving up on Cisco's turf where Cisco now rules alone, leaving the real battle to see if Cisco can pass Lucent and catch Nortel on carrier networks?
TMF Otter: Sort of. As I said, Lucent is significantly behind Nortel in optical networking, and it is trailing in development of optical switching as well. Nortel has a long haul transmission system that can send wavelengths nearly 2500 miles in testing without regeneration. The nearest competition here is Corning (NYSE: GLW) and Corvis (Nasdaq: CORV). Cisco doesn't handle these components, and Lucent's products are way behind.
TMF RFK: Would one of you like to summarize the troubles Lucent has had this year that have given the stock such trouble?
TMF Verve: I think I can tackle that. One, product delays. Two, bloated inventories and receivables, which the company has needed to work down in this area ever since. Three, an incoherent product line-up that doesn't have a unified "secret sauce," such as Cisco's Internetworking Operating System. Four, less mentioned in the press, [is that] Lucent has been losing money on a free cash flow basis.
TMF RFK: Lucent's balance sheet is a mess. Did they make any progress on it this quarter?
TMF Verve: We won't know until the 10-Q comes out.
Lucent must get away from its revenue-driven culture and really focus on generating free cash flow.
TMF RFK: Are there any other signs of progress on that front?
TMF Verve: None as of yet.
TMF Buster: Here's what I think I understand about Lucent's current position. The reasons behind Lucent's crummy Foolish Flow Ratio are primarily, one, they are caught with a lot of old inventory that nobody wants and not enough new stuff that everybody wants badly, and, two, the fact that major telecommunication companies require, according to an age-old industry practice, substantial financing help on big purchases from their suppliers.
As I understand it, this is why Lucent and Nortel can't touch Cisco in terms of balance sheet performance. The question, if this is accurate, is how bad is Nortel's balance sheet and can Cisco maintain their incredible leverage as they move into supplying telcos?
TMF Verve: Nortel's balance sheet quality is somewhere between Cisco's "wonderful" and Lucent's "horrible."
TMF RFK: Is Lucent's biggest challenge then with the products it's offering, its financial management, or both?
TMF Otter: Matt, Tom Gardner, and I wrote extensively about Lucent's financial missteps in January. They seemed to have packed the supply chain and had huge inventories. But they also have significant product problems. Now they're trailing Nortel and running up against Sycamore (Nasdaq: SCMR) on the telco side. People have been counting on optical networking to pick up the slack, but Lucent's projected 15% growth just won't cut it, especially since Nortel's is growing at 45% plus.
TMF RFK: Is Lucent's spin-off of its microelectronics division a smart move, or simply an attempt to improve the balance sheet by dumping this division?
TMF Verve: An attempt. Seriously, it looks like a classic ploy to off-load the crummy businesses to strengthen the remaining whole but, despite my cynicism, it could work if they get their financial house in order and strengthen their product line-up with their recent acquisitions.
TMF Otter: There are advantages to this. The same advantages gleaned by Lucent when it was spun off from AT&T (NYSE: T) -- that is that the old AT&T labs (which became Lucent) were having to sell to AT&T competitors. Not a comfortable situation for vendor or customer. Lucent Microelectronics might get some improvements in the same vein.
TMF Verve: I agree with you on that point, Bill.
TMF Buster: I don't see the spin-offs as a ploy at all. In order for Lucent to get more nimble and take on Nortel with the focus required, they simply had to unload the old enterprise business that was dead in the water -- Cisco wins -- and the parts business fraught with all the problems Bill suggests and more. What Cisco has taught everyone is focus and I don't see how Lucent can focus on the real battle with Nortel without getting down to business.
TMF RFK: Last question. What about those acquisitions, such as Chromatis. Good moves?
TMF Otter: Here's the thing. I think Lucent understands that it has to refocus itself. This is tough to do. The best example of a company re-emerging is Corning.
TMF Verve: For what it's worth, I have a good friend in the CLEC [competitve local exchange carrier] business and he's quite impressed with the optical technology of some of Lucent's recent acquisitions, but that's about all I know.
TMF Otter: I would look for Lucent to go out and add some smaller components to its resurgence. Chromatis fits in there. Now it's about executing.
TMF Verve: Yes, and Lucent MUST get away from its revenue-driven culture and really focus on generating free cash flow through quality balance sheet efficiency.
TMF Buster: As an investor, it's a given that Cisco has the better package. They have written the book on nimbleness via outsourcing everything but customer relationship, knowledge, and brand. The result has been the stellar cash flow that Matt writes so eloquently about -- you too, Bill -- and the ability to move quickly in the kind of dynamic market that Lucent slipped in by being so balance-sheet heavy. So, the question: If not by spinning off its tangential businesses and focusing on the battle with Nortel, how else could Lucent learn from the Cisco model? In other words, what precisely can they do to "clean up their balance sheet"?
TMF Verve: The Cisco model depends on a horizontal model, in which Cisco ruthlessly focuses only on its competency in connecting networks via the best technology available. This focus is capital-efficient because Cisco doesn't try to enter business lines where it doesn't have a competitive edge. To the extent possible, Lucent should also try to adopt this horizontal business structure and partner with other companies to do the manufacturing. Also, Lucent should try to enhance its customer focus across all fronts.
TMF Buster: By, say, spinning off non-core businesses to focus on the backbone fight with Nortel? Is it fair to say that no matter how excellently and swiftly the Lucent execs handle finance over the next year or so, the balance sheet can't turn around until Lucent catches up with its business? Isn't this the real question, more so than the next 10-Q balance sheet?
TMF Verve: The spinoff's not a bad move, but it begs the question why it wasn't done sooner. Anyway you slice it, a discontinued business is a failure. Seriously, the next four quarterly balance sheets should tell the story. I think within the next year, the balance sheet should at least begin to tell the story of whether a turnaround is in the works. I'd watch the Flow Ratio. Just as I've written before, Lucent's Flow Ratio is one of the worst cases of out-of-control working capital management that I've ever seen.
TMF Otter: If I see lower receivables and inventory, I'll know that Lucent is taking some short-term pain for long-term gain.
TMF Buster: But their flowie sucks because they have no competitive advantage, more than the other way around, right?
TMF Verve: I think their lack of competitive advantage could've revealed itself in sales growth much sooner.
TMF Buster: So should Lucent just have gotten it over with and written off all the inventory that nobody wanted?
TMF Otter: Lucent should have had pricing power and/or terms power with its vendors and customers, but it chose to pack the supply chain instead.
TMF Verve: Yep, and apparently Lucent's mode of operation is "more revenue, more revenue, more..." Yes, and Lucent shouldn't have kept extending ever-more-lenient credit to its customers.
TMF RFK: OK, that should wrap it up. Thanks to everyone for participating!
TMF Verve: Thanks! In closing, Lucent may well be in the midst of a turnaround, but I'll believe it when I see it. Over and out. |
