nytimes.com
January 21, 2001
How Missteps and Overreaching Dimmed
Lucent's Promise
By SETH SCHIESEL
This article was reported by
Alex Berenson, Simon
Romero and Seth Schiesel, and
was written by Mr. Schiesel.
For a company the size of Lucent
Technologies, which had $33.8
billion in revenue in its last fiscal
year, $20 million is not a lot of
money. At least it wasn't until last
August.
That was when Mahesh Ganmukhi
tried to collect the final payment
that Lucent owed him for buying
his optical communications
start-up.
Lucent, the world's biggest maker
of communications equipment, had
bought control of Mr. Ganmukhi's
company, Ignitus Communications,
for $105.6 million in April. Four
months later, Lucent shut down the
main Ignitus project and said it
would pay Mr. Ganmukhi $20.25
million on Sept. 1, according to a
lawsuit filed by Mr. Ganmukhi in
federal court in Boston last fall.
But on Aug. 31, the company asked Mr. Ganmukhi to defer his payoff
until Oct. 1 because of "accounting and financial reporting
considerations," the lawsuit said.
As it happens, Lucent's fiscal year ends in September. Deferring the
payment until October could have allowed the company to keep the $20
million on its books for the year. Lucent, its stock decimated and about
to miss its financial targets yet again, apparently wanted that $20 million.
Lucent disagrees. "It certainly had nothing to do with meeting the financial
reporting requirements for the fourth quarter," said Kathleen M.
Fitzgerald, a spokeswoman. In late December, Lucent settled the suit for
undisclosed terms.
In any case, on Oct. 10, Lucent announced that it had missed its financial
targets for the quarter that had just ended, the third of what would
become four warnings last year. Within weeks, Richard A. McGinn —
Lucent's chairman and chief executive and hero of the information
revolution — was dismissed from his job, a victim of his own, and Wall
Street's, outsized expectations.
In a humbling turnabout for a company that emerged from AT&T in
1996 and soon outperformed Ma Bell, the company's éminence grise
and former chairman and chief executive, Henry B. Schacht, has returned
to his old jobs. And last month, Lucent said it would restate its financial
results for the quarter ended in September by reducing revenue by $679
million, essentially because the company had been too aggressive in
recording sales. Its stock, which made its debut at a split-adjusted price
of $6.38 on April 4, 1996, and soared as high as $79.58 on Dec. 10,
1999, closed on Friday at $20.56.
When Lucent announces its quarterly results on Wednesday, Mr.
Schacht, 66, intends to reveal the details of his restructuring plan. It will
include layoffs, a significant charge, a revamping of the company's internal
computer systems and other changes in the operational structure.
Lucent has acknowledged that it made a bad technical bet, falling behind
in the crucial optical communications sector. In fact, had Lucent
succeeded in the optical arena, Mr. McGinn might still have his job. But
Lucent's problems went far beyond technology and included unrealistic
expectations, too much bureaucracy, falling morale and a failure of
internal executive oversight.
A Fateful Meeting
In several important ways, the trouble started on Sept. 17, 1998.
"That's when the arrogance began," said Steven D. Levy, chief
communications equipment analyst at Lehman Brothers, who saw the
problems coming as early as 1999.
As Mr. McGinn met that day with analysts and investors at Lucent's
headquarters in Murray Hill, N.J., he was flying high. No longer
concerned that buying AT&T's equipment meant subsidizing AT&T
phone operations, potential customers who had previously shied away
were ready to deal. Press coverage was glowing.
Apparently believing that he had left behind Lucent's musty Ma Bell past
and remade the company into a digital dynamo, Mr. McGinn, according
to financial analysts who were there, said Lucent would grow by as much
as 20 percent a year.
"If you turn your head and mind back to fall of '99, early 2000, the
market was valuing revenue growth, and revenue growth was the mantra
for our industry," Mr. Schacht said in an interview last Wednesday.
"Everybody in this industry was revenue-driven. And it didn't work."
At first, Lucent was able to meet Mr. McGinn's targets; the company
grew by 20.4 percent in its fiscal 1999. But in little more than a year,
Lucent began cannibalizing itself as it tried to make the numbers.
At the higher reaches of the communications equipment business, list
price does not mean much. The biggest customers for companies like
Lucent and its archrival, Nortel Networks of Canada, spend hundreds of
millions, if not billions, of dollars a year on their products. Big customers
get big discounts, especially when suppliers are trying to make year-end
sales targets.
"We first saw this issue at Lucent at the end of 1999," said an executive
at one of Lucent's biggest customers, speaking on condition of
anonymity. "There's always some deal at the end of December and
everyone does it. But Lucent did it to an extreme in the fourth quarter of
1999. Typically, you're dealing with discounts of 10 to 15 percent in the
last days of the year and in Lucent's case they were probably coming in
closer to 20 to 25 percent."
The discounts did not help much. On Jan. 6, 2000, Lucent announced
that it had missed Wall Street's per- share earnings targets for the
previous quarter by more than 25 percent.
But Lucent's new aggressiveness went beyond the size of the discounts.
"They offered discounts not only for that quarter but also on stuff that we
were going to buy in 2000," the customer said. "That was a huge change.
We typically had not received future discounts, only on the stuff we were
going to buy right there and then."
As Mr. Schacht put it, "As we got further and further behind, we did
more and more discounting." That, he added, threw the sales force and
manufacturing operations crew out of sync.
Besides the shortfall in its optical group, which failed to keep up with
Nortel, Lucent faced another big cash crunch: it lost about $2 billion in
expected revenue from two of its biggest clients, AT&T and the
government of Saudi Arabia, which slowed aspects of their overall
spending and moved some business to Lucent's rivals.
Soon, Lucent's discounting caught up with the company.
"There was a conscious decision made to meet the revenue growth, to try
and meet the revenue growth by pushing and pushing, which resulted in
increasingly heavy use of discounts to pull forward the profits of our
existing business with the expectation that our new businesses would fill in
the hole that was created," Mr. Schacht said. "When the new business to
fill in the hole wasn't created, you darn well wish you hadn't discounted
the way you had."
Too Many Cooks
Lucent's complex internal structure, with its competing fiefs, did not help
matters. Some customers threw up their hands as different Lucent
divisions battled one another to make sales.
Lucent had broken itself up internally on purpose, in the hope of creating
smaller, nimbler units, each with its own leaders.
"Not surprising, they said, `Well, if I'm a general manager, I need my
own P.& L.' and `I'm going to run this as if I owned it' and `Get out of
my way,' " Mr. Schacht said, referring to profit and loss responsibility.
"And so they each had their own market organization. Then very quickly
they each had their own sales organization. They had their own plants.
They had their own purchasing agent."
Mr. Schacht said that if the company had sustained its revenue growth
target of 20 percent, it could have supported such a structure.
Roderick K. Randall saw the problems firsthand. He had begun his
career at Lucent's Bell Laboratories, left to help found a company in
1987 and returned to Lucent in 1998 when it acquired Ascend
Communications.
"It was very hard to get agreement or cooperation between different
units," said Mr. Randall, who before leaving to join a venture capital firm
last year was chief marketing officer for Lucent's biggest unit, which sells
equipment to communications carriers. "An example? Take a look at the
softswitch."
To outsiders, Lucent has said a lot in recent years about its effort to
make a "softswitch," a communications switch that can be programmed
by outsiders, in somewhat the same way as a personal computer can be
programmed by anyone who learns how. But there was not just one
softswitch.
"There were several softswitch efforts: some from Ascend, some from
Lucent, some from Excel," Mr. Randall said, referring to Excel
Communications, a company that Lucent acquired in November 1999.
"There was one from the research division, one from the next-gen
product division, one from the switching division; there was one from an
internal Lucent ventures division, one from the wireless division. Oh yeah,
and there was one from the optical division, all different flavors."
(Last week, Lucent announced that it had developed its "second
generation" softswitch.)
Mr. Randall, who said he is in a dispute with Lucent over an outstanding
bonus payment, recalled an experience with a large local phone company
that wanted to build an advanced network to carry both voice and data:
"They said, `I fully understand what Nortel is doing and I fully understand
what Cisco is offering, but I'm confused on what Lucent is actually
offering, because I've heard different descriptions of the same solution
from different Lucent teams.' "
Mr. Randall said he did not know whether the customer ended up buying
Lucent's gear or not.
Behind and Under Pressure
Lucent has been frank about its missteps in the optical communications
business. Beginning in 1996, the company ceded the high ground in the
optical market to Nortel, which took a commanding lead in developing a
new generation of equipment that could transmit 10 billion bits of
information a second.
In fact, Mr. Schacht said that if the company had succeeded in the
optical area, Lucent's other problems would not have become so
important. "Hit optical — you can have this debate about managerial
mechanisms later," he said.
But there were human costs, as well as financial ones, to the optical
mistake. Tales of anxiety are common in the telecommunications industry.
But the story told by Elaine L. Webb, a 13-year Lucent employee who
was a senior manager at Lucent's flagship optical factory in North
Andover, Mass., goes a bit beyond the ordinary.
In an affidavit she filed in support of 10 former co-workers who were
sued by Lucent after they quit to join Cisco Systems, Ms. Webb said
that between 1997 and 1999, conditions at the plant grew steadily more
stressful. Ms. Webb said that in March 1999, Eldred F. Newland, the
plant's manager, demanded that North Andover double its optical
production.
To help meet that goal, she said, Mr. Newland held staff meetings at 6:30
every morning, including Saturdays and Sundays. "He would yell at
people during these meetings that we were not going to meet our goal of
doubling production for the month of March 1999," the affidavit said.
"The stress was so severe that there were days that it took me quite a
while to get out of my car in the parking lot," Ms. Webb said in the
affidavit. Over one month, she said, she lost 20 pounds.
Carolyn Collins, director for inbound logistics at the North Andover
plant, said she has had a different experience with Mr. Newland, who
declined to comment. "He expects to understand different aspects of the
business, but I never felt abused," she said. "In fact, I feel like I've been
very well treated."
Ms. Webb, who took a leave of absence in April 1999, after helping to
meet the production goal, resigned from Lucent last May without having
returned to work, after former co- workers told her that stress at the
plant had only increased.
"Lucent was burning people up," Ms. Webb said in an interview earlier
this month.
Ms. Webb was not the only one leaving Lucent. In December, for
example, 2,000 employees left the company, according to Tom Lauria, a
former Lucent executive who is now an analyst at ING Barings. Lucent
said that half the total retired or left at the company's instigation.
Nevertheless, over the last year, Lucent has lost some important
managers.
Morale fell so much that it attracted the notice of rivals. Last August,
Nortel's Qtera unit flew a plane over Lucent's huge buildings in Holmdel,
N.J., with a banner trailing behind it. It read, "Are your options losing
altitude? careers@qtera.com."
Ethical Gray Areas
Perhaps the most confounding aspect of Lucent's slide was the apparent
deterioration or absence of internal controls. The company never
developed systems that allowed the necessary visibility into its sprawling
operations, as Mr. Schacht acknowledges. That is one big reason that
the company kept missing financial goals.
Lucent also appeared to lack sufficient controls over its people and over
personal investments by executives that might be viewed as posing
conflicts of interest.
The tangled tale of Lucent's investment in a Swiss company called
Fantastic offers a prime example. In June 1999, Lucent agreed to
become a reseller for Fantastic, which develops software to send data
over high- speed networks. Over the next six months, Lucent bought $10
million worth of Fantastic software, representing more than 40 percent of
Fantastic's revenue that year.
As part of the deal, Lucent also bought a small stake in the Swiss
company, Lucent said. In a 1999 securities filing in Germany, Fantastic
said it sold two million shares (adjusted for splits) for about $8 million to
a "strategic business partner" — Lucent.
But Lucent was unable to find any buyers for the $10 million of
Fantastic's software, according to two former Lucent executives, both of
whom spoke only on condition of anonymity. Representatives of Lucent
and Fantastic said this month that they had gone on several "joint sales
calls," but declined to name any Lucent customers who bought the
software.
Neither Lucent or Fantastic would discuss details of the contract
between them. But it may have given Lucent the right to return the
software to Fantastic as unsalable, a fairly common condition in the
communications industry.
If Lucent had returned the software, Fantastic probably would have had
to restate its 1999 revenue, lowering it to $13 million from $23 million.
That would have hurt the value of Lucent's stake in Fantastic's stock,
which had soared after Fantastic's public offering in September 1999 on
Germany's Neuer Markt.
But Lucent did not return the software. In March 2000, when Fantastic's
shareholders still believed that the partnership was a commercial success
and Fantastic's stock was trading for about 35 euros — or about $35 —
a share, Lucent sold its Fantastic shares for a profit of roughly $50
million. Lucent, meanwhile, wrote off the software as worthless,
according to one former Lucent executive, also speaking on condition of
anonymity. Lucent would not comment on whether it wrote off the
software.
Last month, after missing its sales forecasts for the second time in 2000,
Fantastic announced that it would lay off 30 percent of its employees.
Fantastic stock now trades at 3.12 euros — less than $3.
Lucent was not alone in profiting from the Fantastic deal.
Harry J. Carr, vice president of Lucent's broadband carrier networks
group, the unit that dealt with Fantastic, also invested privately in the
Swiss company. In an interview, Mr. Carr said that after making his
investment, he recused himself from all Lucent matters related to
Fantastic. He added that he fully followed Lucent's rules about personal
investments at the time, including disclosing his investment to the
company.
Mr. Schacht would not comment on the Fantastic situation. But he said
Lucent executives are now barred from investing personally in the
company's suppliers or customers. "I'm not making any accusation or
even any statements about doing it, because I have no evidence to
suggest it hurt anything," Mr. Schacht said. "I just think it's borrowing
trouble and I prefer not to do it. So we've stopped it."
Meanwhile, another Lucent employee was able to violate the company's
rules.
Winstar Communications Inc., a local communications carrier, has been a
significant Lucent customer for years. In Lucent's fourth fiscal quarter,
which ended in September, Winstar bought some software.
Winstar was simply taking advantage of a good deal. The problem was
that Lucent's finance officials did not know just how good a deal it was.
After Mr. Schacht took over, he ordered a comprehensive review of
Lucent's sales accounts. It turned out that a senior salesman who focused
on smaller carriers had offered Winstar discounts on future purchases as
part of the fourth-quarter deal, according to people close to the inquiry.
But the salesman hid the discounts from Lucent's finance team and did
not subtract their value from the revenue he reported to headquarters.
When the deception was discovered, Lucent revised its quarterly revenue
downward by $125 million to reflect the discounts.
Winstar declined to comment. It does not appear that the salesman, who
Lucent says was dismissed, was trying to enrich himself through
enhanced commissions. Rather, it appears that he simply went too far in
trying to help the company meet its revenue targets.
The Winstar fiasco appears to have been unique. Nonetheless, the
episode speaks poorly to the company's previous control system and,
perhaps even more tellingly, may reflect the pressure that the company's
sales force came under as Lucent struggled to meet its financial goals.
While refusing to comment on specifics, Mr. Schacht said, "In one case
out of hundreds of transactions, one person did something they shouldn't
have done."
Picking Up the Pieces
The most unfortunate aspect of Lucent's travails is not Mr. McGinn's
dismissal; though he has not completed a severance agreement, he is
entitled to a pension of about $1 million a year. It may not even be the
disappointment of employees and shareholders who watched Lucent's
stock price wither; adjusted for splits, Lucent's shares are still trading at
roughly three times their initial value.
Instead, the most unfortunate part may be that the recent problems can
obscure the company's legitimate accomplishments since its split from
AT&T in 1996.
In its final year as part of AT&T, the operation now known as Lucent
had revenue of $21.4 billion. In fiscal 2000, that figure was $33.8 billion.
When it emerged from AT&T, Lucent had a minimal international
presence. Now, overseas customers account for about 34 percent of the
company's sales. Five years ago, Lucent had no business to speak of in
providing equipment for the Internet and other sorts of advanced data
networks. Now, Lucent's data operations generate almost $5 billion in
annual sales.
In a statement, Mr. McGinn said only the following: "The past 24 months
have been a period of enormous capital investment by communications
carriers worldwide. While many divisions were growing smartly and
taking share, Lucent did not sustain its marketplace leadership when it
missed a critical product cycle in optical systems. As investment
recovers, Lucent will reassert itself because of its R.& D. strengths and
the quality of its people."
Mr. McGinn, the man in charge at the time, must ultimately bear the lion's
share of the responsibility for Lucent's troubles. The company's board
must also share some blame, though Mr. Schacht, a director from
Lucent's outset, dismissed the suggestion that the board should have
known more and acted sooner.
Pointing out that Mr. McGinn had driven Lucent's market value to more
than $270 billion (it is now worth about $70 billion), Mr. Schacht said:
"In retrospect, when you change your C.E.O., you always wish you'd
done it sooner. But does a guy who's delivered that kind of performance
get to miss a quarter? Darn right. Would any board, having been
delivered that kind of performance, move sooner? I don't know."
Perhaps. But the warning signs should have been clear. The ever more
aggressive discounting, the company's weakening balance sheet and the
missteps in optical networking were signposts on the road to trouble.
Now Lucent must deal with that trouble. On Wednesday, it expects to
announce a loss for the most recent quarter on revenue about 20 percent
lower than in the year-earlier period. While the number of layoffs is
unclear, a restructuring charge will probably come to hundreds of millions
of dollars, at least.
Lucent has hired a search firm to find its next chief executive. Mr.
Schacht, however, has shown no eagerness to get back to being solely
the chairman of Avaya Inc., a Lucent spinoff, and a director of many
companies including The New York Times Company. And it is at least
possible that he will still be running Lucent at this time next year. Until he
leaves, he will certainly have enough to do, and he knows where he
wants to go.
"I've gone to see all the major customers domestically," Mr. Schacht
said. "And it's really interesting, because they all say, `We want you back
in the game.' And that's a phrase we started using internally, `Let's get
back in the game.' "
KJC |
