SSB:LU is VALUED AT $70-$75 ON BREAK UP
Lucent Technologies, Inc. (LU)#
LU: MICRO SPIN NOT ENOUGH--VALUE AT $70-$75 ON BREAK 3H (Neutral, High Risk)
UP Mkt Cap: $215,611.8
mil.
July 21, 2000 SUMMARY
* Lucent reported earnings $0.01 ahead of consensus
TELECOMMUNICATIONS at $0.30, but management lowered guidance over the
EQUIPMENT next two quarters and for the fiscal 2001 year
B. Alexander Henderson * Our first blush analysis suggests LU is trading at
only a modest discount to its break-up value
estimated on the order of $70-$75
Timothy Anderson * Growth rate of optical systems looks flat y-o-y
excluding OC-192 and fiber pieces, sharply behind
the market and expected rates for Nortel
* We still think the comparisions with Nortel's
release on Tuesday will further taint the investment
well for Lucent
* Pro forma DSOs of 99 days, but microelectronic
business' DSO are 44 days
* Pending spin of microelectronic business is nice
positive, but with a number of businesses headed out
the door, management distraction is a nagging
concern
* Despite a tone of reconcilliation on the call, the
lowered guidance and a confusing presentation
suggests strong challenges remain in the cards
OPINION
WE THINK LU WILL TREAD WATER FOR AT LEAST 3-6 MONTHS AFTER
THIS LATEST DEBACLE--RETAINING NEUTRAL RATING AND $65 TARGET
PRICE
After sifting through the earnings release thinking through the spin off
values and comparing the Lucent resutls to the expected Nortel results, we
conclude theres value in Lucent, but its not likely to be realized quickly.
We think the comparision with the exceptional results we expect out of Nortel
next Tuesday will add to the perceptual taint and further erode investors
confidence in the outlook for Lucent. We think theres a good chance Nortel
will increase its guidance when they release their results. The current
revenue guidance is for revenue growth of 25%-30% adjusting to proforma for
Masa or 30%-35% as reported. We think Nortel could hit 40% growth in 2000
and this could cause even more consternation for Lucent shareholders'.
The following comparisions in particular are likely to hurt:
Lucent's Optical Systems Products Growth, Up 27% Including Fiber Sharply Lags
The Market, And The Expected Triple Digit Growth At Nortel. On the call,
management indicted it was disappointed with the pace of sales in its systems
business. Management indicated optical systems and fiber sales grew roughly
27% year over year in the quarter. Based on the fiber business at roughly
$1.2 billion in trailing annual revenue, and growing at a minimum of a 50%
annual rate, and using roughly a $1 billion in per quarter optical revenues
for last year, about $4.0 billion in trailing annual revenues, we calculate
the growth in the optical systems business at aroung 20% year over year
adjusting for fiber. This rate is sharply behind Nortel. Nortel is likely
to more than double its optical systems business this year, and we believe
its should exceed its $10 billion guidance mark. Having just won two high-
profile multi-billion dollar contract extensions with WorldComm and Williams,
Nortel looks like it is pulling well ahead of Lucent. In fact, we think
Nortel will up its guidance for this unit for the full year when the company
reports.
Wireless Struggles Up Only 18% Resulting In Market Share Losses--Lucent
Blames A Specific Contract Being Ramped Down. Wireless is an important
business for Lucent with roughly $5.5 billion in annual revenues. We think
Lucent's wireless business is well positioned and should at least be able to
hit market performance over the next several years. However, the most recent
quarter came in up only 18"% compared to a market expected to grow at a 20%-
25% pace. Again, the comparision with Nortel won't help Lucent. We think
Nortel's wireless will be up over 25% in the quarter. Given Lucent and
Nortel's relative performance we think Lucent's losing share and Nortel's
gaining share. Moreover, the commentary on the constract ramp down suggests
this will continue to pressure wireless results for another several quarters.
CO Switch Business Declines--Slow Uptake On Softswtich And 7RE Perfomance
Cited--We Think Nortel's CO Switch Business Will Be Flat To Up And WIll Be Up
In The Second Half--At Least This Units Declining As A Percent Of LU's Total
Business. Management indicated it was disappointed with the performance of
its softwsitch business and 7RE products. These products are Class 4 and 5
'replacements' designed to help local voice carriers bridge the gap between
voice and data networks. Management blamed the service providers as taking
longer than exptected to trial the new products. This is somewhat
diappointing news. We had looked for the 7RE to perform at a faster pace.
Comments from sales people on the floor of SuperCom suggested a better rate
of uptake. With well funded start-up like Sonus, and Cisco and Nortel
offering their own solutions, Lucent needs to move quickly in this market to
sustain its position. Nortel has announced several visible contracts for its
Succession line and we think their CO switch buisiness is holding up better
than Lucent is indicating theirs has fared. Lucent cited the decline in the
CO switch business as a percent of sales as a positive. Conceptually, we
agree. However, we think the rate of decline in the percentage is
considerably less than the rate of decline as a percentage at Nortel. Given
Nortel's strong top line growth, we expect CO switches to decline from 22.5%
of revenues in 1999 to under 10% in 2001.
Fiber Doing Well. Lucent is a premier provider of fiber optics, and number
two in market share next to Corning. The pace of fiber deployments continues
to shine, and although management did not provide specific commentary, we
believe Lucent is seening at least market growth from this business,
somewhere on the order of 50%-70% a year.
DSOs Came In At 99 Days, And With The Microelectronics Busines Running At 44
Days The Core Lucent Business Has A Problem, But New Controls Are Moving Into
Place. When the micro electronics business is spun-out, if Lucent keep the
pace exhibited in fiscal 3Q, DSOs would gap higher. The new CFO, Deborah
Hopkins emphasized she is implementing much more stringent cash collection
proceedures, which we beleive should sharply improve performance in coming
quarters. Ms. Hopkins has a strong track record. In our opinion, we believe
the DSO issues should resolve itself over the next year. However, doing the
math on the DSO suggests the DSO excluding the Micro spin piece yeilds a rate
of 106 days for ongoing Lucent. This is roughly in line with Nortel's DSO
last quarter of around 103 days.
Spin-off Of Micro Electronic Unit Should Help Unlock Tangible Value For
Shareholders. Lucent's choice to spin out its micro-electronic and optical
component businesses should recieve a nice reception from the market.
Splitting Lucent into four pieces for valuation purposes including the
discountinued Enterprise operation, the Optics piece of the Micro spin, and
the chip piece of the Micro spin and then valuing the ongoing Lucent piece.
We come out with the following back of the envelope calculations. We plan to
do a more detailed analysis as time permits after quarterly reporting winds
down.
* Enterprise--Valued At $8 Billion--At roughly one times revenues Enterprise
should fetch roughly $8 billion. This unit has little impact on the
overall valuation.
* The Micro Optics Valued At $45-$50 Billion. We believe investors will be
intrigued by this piece. Giving this unit a generous comparision to SDLI
and JDSU which carry valuations of roughly Piece Based On The Valuations
of JDSU, SDLI And Corning Should Fetch Roughly 20-25 Times 2001 Revenues
Of $2 billion Or Roughly $50 Billion. Based on 20 times this unit yeilds a
value of $40 billion and on 25 times it yeilds a value of $50 billion.
This compares to 21 times and 34 times for SDLI and JDSU on 2001 revenues.
We think this unit should be at a discount to those names.
* Micro Chips Business--Value $$20-$25 billion. We think Texas Instruments
is the best comp to the chip piece of the Micro spin. Its growing at
roughly a 20% topline pace which is the same rate as the Micro chip unit.
TI is trading at 4.2 times revenus which is actually below the valuation
of Lucent as a whole. Looking at the much smaller and faster growth
Vitesse the valuation is at 21 times 2001 revenues. We think the growth
of Vitesse at 2X the rate of the Micro chip business should receive a
substantial premium. We are using a generous valuation on the chips piece
at 5.5 times 2001 revenues. THis is a 31% premium to TI.
* Ongoing Lucent--Value $160 Billion. The biggest peice of the valuation
equation remains the ongoing Lucent operations. This unit is likely to
receive a price to revenues valuation of between 4 and 4.5 times 2001
revenues. The entire company is currently trading at roughly 4.3 times
2000 revenue and 3.6 times 2001 revenues. Based on 4.5 times revenues,
our analysis values the ongoing Lucent at $160 billion. We point out that
if the valuation of this unit shifts by 0.5X 2001 revenues the value of
Lucent moves by $18 billion. Using 4.0 yeilds a value of $65.88 for LU
and using a 4.5 X multiple yields a $71.22 value.
Combining these pieces yeild a valuation target for the full company at $70-
$75 per share, however, given the transaction costs and the performance risk
and the timing issues, we think our $65 target remains reasonable.
New Optical Electronic Unit, Should Immediately Be A Strong Player In The
Market. The new unnamed entity, when unencoumbered from its parent, should
be in a strong position, with deep relationships streatching through out both
the telecommunictions service provider and computing manufacturing markets.
By freeing up the unit from strategic conflicts, we look for the business to
gaining customers and modest share out of the box. Captured in this new
entity is roughly $1 billion in optical component revenues. This would make
the unit one of the top two or three optical component manufacturers in the
world. For the combined business, here are some of the key metrics
management mentioned on its second conference call:
* Revenue is $4 billion, with $1 billion comprised of optical sales to
Lucent's systems business
* Revenue Growth iscurrently growing at a 39% annual clip on the top line,
which should be sustainable in the coming year.
* Margins are anticipated to track closely with industry competitiors,
implying somewhere in the neighborhoon of 20%, give or take a few points.
* Optical sub-unit's revenue growth is at nearly a triple digit anual rate,
and in keeping with the pace in the industry.
* Integrate circuit sub-unit's revenue growth rate implied from the optical
sub-unit growth and the overall business pace is on the order of 18%-20%
annually, this is also in keeping with the pace of the industry
Why Marry An IC Business With An Optical Business? The bulk of components,
active and passives, are discretely manufactured from doped silicon or doped,
irradiated, or coated silica glass. However, form factors are shrinking and
components combining. Next generation component fabrication techniques are
borrowing heavily from the metrology and processes developed for integrated
circuit manufacturing. This is particularly true of planar wave guides. In
theory, lasers, photonic amps, modulators and DWDMs can all be grown on
wafers therefore, putting an optical business and IC business together makes
sense. There are synergies. What Lucent is doing is not irrational, there
is a reference in the early development of the aerospace industry. In the
early 1900s, airplane manufacturers borrowed and adopted shipbuilding
technologies and processes to build a competely new form of transport. Many
airframe manufacturers grew-up out of the boat-house. IC manufacturers know
how to grow silicon substrates, and dope and etch. In fact, creating
reflective and refractive surfaces on silicon is markedly similar to creating
conductive surfaces.
OC-192 Interfaces Hit $250 Million Target, Next Up Is $750 Million Hurdle
Which Looks Achievable. Like the majority of component manufacturers, Lucent
is attepmting to stay on a 12-18 month development cycle with componentry.
The continued refinement of 2.5Gbps and 10Gbps interfaces are anticipated to
play a key role in growth of the systems business as well as the to-be-spun-
out microelectronic unit. According to management, Lucent achieved $250
million in OC-192 transcever sales as the product just started to ramp in
fiscal 3Q. Management indicated it can acheive $750 million in sales next
quarter. We beleive Lucent's ramp rate and capacity is sufficient to achieve
the goal. Management commented margins on the OC-192 came in lower than
desired, as volumes ramp, we look for the margin contribution to improve.
With Three Units On The Way Out The Door In Six Months, Potential For
Management Distractions Mount. One of the concerns that has keep the SSB
team on the sidelines with these shares is the potential for management
distrations during the spin-out of Avaya. With the microelectronics business
next to go, and the power business assets yet-to-be repositioned, we believe
there is a fair amount of pressure on Lucent's management teams. With the
data networking and telecommunictions rapidly evolving, particularly in
optical and in packet processing, it would be easy for one of the balls to
drop. The expereince and tallent Lucent has in its management team is a huge
positive factor, but the number of challenges are equally daunting.
Foreign Contract Weighs Heavily, Impact To Continue. Management indcated a
slow down in a foreing project significantly impaired international sales
growth. Outside the U.S. sales increased only 4%. We believe windown in the
wireless and circuit switch projects Saudi Arabia are to blame. Excluding the
foreign project, management indicated non-U.S. sales grew at a 22% pace year
over year. This issues is expected to hit fiscal 4Q 2000 and fiscal 1Q 2001
results hard. The individual operations impacted included wireless and
circuit switching. On a year over year basis in the quarter, circuit
switching grew 1%, and the wireless business grew 18%. |
