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 4-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.
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.
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? |
