October 27, 1999
Shedding Light on Lucent
By Alec Appelbaum
LIKE PARENTS watching their normally rowdy kid spike a fever
and turn sluggish, investors may have wondered what was ailing
Lucent Technologies (LU) this fall. Analysts began fretting
about a couple of obscure accounting measures, and shares in
the communications-equipment giant slumped 27% over 13
weeks. Now the fever seems to have broken: On Tuesday, the
company wowed the Street by reporting higher-than-expected
sales growth -- and perhaps more important, improvements in
those accounting statistics. The question now is whether
Lucent's problem was just a passing malaise or something
more troubling.
So what was worrying Lucent investors? Mostly, it was two
lines on the balance sheet: inventories and days sales
outstanding, or DSOs. If a company reports high inventories,
that means it may be making more than it can sell; if it has high
DSOs, that means it may be giving its customers a lot of time
to pay bills and thus booking revenue that it hasn't pocketed
yet. Now, nobody was accusing Lucent of cooking the books.
But many analysts have long wondered whether the company
could keep its revenue growing at the same breakneck pace. And if growth were to start to slow, where do
you think the signs might show up first? Below the headlines, in obscure accounting items like inventories
and DSOs.
On the whole, investors have applauded Lucent's evolution from a clubby spinoff of AT&T (T) to a
multifaceted networking powerhouse. But they've always wondered when demand from big businesses
would slack off, or when fast-moving rivals would snag new customers. Lucent stoked the suspicion a bit
this past spring, at the end of its second quarter, when it disclosed that it had not yet wrapped up two big
contracts worth about $800 million -- yet its DSOs were rising. That didn't jibe, says portfolio manager
Ned Brines of the Phoenix-Engemann Aggressive Growth (PHSKX) and Focused Growth (sorry, no
snapshot available) funds, whose company holds roughly seven million Lucent shares. If DSOs are rising
on a smaller number of sales, then maybe previously reported revenue is coming into the company coffers
haphazardly or not at all.
Like all bogeymen, the high DSO number was scariest for what might have been behind it. A high DSO
number raises alarms about future growth. After all, a company that is scrambling to meet Wall Street
estimates might hand out sweetheart payment terms to customers to boost revenue. So concerns about
Lucent's balance sheet, says Paul Sagawa of Sanford Bernstein, were just code for nervousness about
continued revenue growth. Similar whispers about sagging future growth also knocked down Cisco
Systems (CSCO) last week. Investors may be talking about auditors' rules, but they're really worried
about Newton's law. (By contrast, Nortel Networks (NT), another huge phone-equipment provider, has
reported higher DSOs than Lucent, but has driven its stock price up all fall by dishing out detailed product
and contract news, allaying growth worries.)
As it turns out, Lucent's DSOs might be climbing for perfectly valid reasons that relate to the company's
focus on fast-growing markets. Remember, Lucent was born as a phone-equipment business that got big
revenue from big sales of big equipment and grew at a nice, predictable rate. Then the Internet happened,
and phone companies started racing to buy the latest equipment to offer Internet and data services over
their networks. Cisco came from out of the West to encroach on Lucent's turf. Lucent started making
more and more sales to startup carriers and overseas outfits. You'd expect Bell Atlantic (BEL) to pay its
bills within 90 days; a company that has no earnings, or that has to convert its currency in and out of
zlotys, tends to take longer. Hence the DSO problem.
Money heals such worries, and this most recent quarter has silenced fears, with its $10 billion in revenue
and 20% annual growth. The company also managed to reduce inventories by 3% from the previous
quarter and DSOs by two to five days, depending on your methodology. The sight of falling inventories
amid so many new sales impressed investors, and Huachen Chen, portfolio manager with the
Dresdner/RCM Global Technology (DRGTX) fund, took heart in CEO Rich McGinn's promise to
increase revenue 3 to 5 percentage points ahead of the market. And the company's focuses on software,
optics and consulting promise continued high revenue growth, according to Christin Flynn and Kitty
Weldon of the Yankee Group.
These emerging areas won't make Lucent's accounting any more soothing, though, because they can
cause considerable DSO discomfort. Software, especially, can be classified as a service or a product,
making it hard to account for consistently. The competition doesn't help: Cisco reports DSOs around half
the size of Lucent's, partly because it sells a lot to private businesses that tend to pay bills promptly.
Lucent spokesman Jeff Baum warns that DSOs are always going to be somewhat high as long as the
company sells to startups and overseas carriers, which are two of its biggest growth areas. But the
company seems serious about solving the problem. Specifically, Phoenix-Engemann's Brines expects the
company to convert more energetically customers' past-due bills into loans that it can sell to other
investors. Baum says that employees are seeing some of their compensation linked to better revenue
collection, and McGinn himself has promised to be more involved in the effort.
So is Lucent safe from a relapse? Like any bellwether stock in a volatile industry, it's vulnerable to rumor
and exposed to risk. But bullish analysts felt vindicated by its strong numbers yesterday; Walt Piecyk of
PaineWebber challenged the skeptics to produce an example of bad inventory management. "It's pretty
clear that concerns were overblown," he says. While more fears about revenue growth could produce
another case of the blahs for Lucent stock, a quick checkup of its balance sheet makes it look pretty
healthy for the long term. |
