Conference Call, 07/23/98, Lucent Q3

FOOL CONFERENCE CALL SYNOPSIS*
By Erik Smith ([email protected])

Lucent Technologies
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600 Mountain Ave.
Murray Hill, NJ 07974
Ph: (908) 582-8500
http://www.lucent.com

ALEXANDRIA, VA (July 23, 1998)/FOOLWIRE/ -- Networks and communications leader Lucent Technologies reported third quarter 1998 earnings (before charges) of $435 million, or $0.32 per share, on revenue of $7.2 billion. Estimated earnings per share had been $0.27.

On the Call:

Don Peterson, EVP, CFO
Ben Verwaayan EVP, COO

Performance Highlights
Lucent's net income more than doubled its year-ago $213 million, and earnings per share increased 88% from $0.17. These figures exclude one-time charges of $668 million for the write-off of in-process research and development (R&D) related to acquisitions of Yurie Systems and Optimay. Also included in the results for the quarter is a $50 million pretax ($32 million after-tax) reversal of business restructuring charges. Including one-time charges related to the acquisitions, the dompany reported a third fiscal quarter 1998 net loss of $233 million, or $0.17 per share.

Gross margins reported at 44.5% while operating margins improved to 10.6% from 6% for the year ago quarter. Selling, general and administrative expenses (SG&A) represented 21.7% of revenues compared with 22.1% last year. Research and development, as a share of revenue, rose slightly to 13.1% compared with 12.9% a year ago. R&D is increasing in response to immediate market opportunities in high growth areas, such as wireless systems, data networking, optical networking, and switching and access systems.

Lucent credited its rise in earnings to higher revenues, a favorable sales mix, and Lucent's continued focus on operational discipline. Revenues of $7.2 billion were up 19.2% on a continuing operations basis, and up 14% compared with same quarter results from a year ago. Continuing operations exclude revenues from the prior period of Lucent's former Consumer Products business, which became part of Philips Electronics and Lucent's former Advanced Technology Systems business, a small service business that Lucent sold. Lucent believes it is succeeding in its efforts toward smoothing out of the seasonality of the business. The company projects continued strength in the U.S. market. Sales outside the United States improved 26% due to sales both to service providers and enterprise customers. Lucent feels this is very encouraging, especially in light of the softness of markets in much of the Asia Pacific region.

Balance sheet
Cash grew to more than $1 billion, while inventory increased $47 million, or 1.6% to about $3 billion. Contracts-in-progress increased $359 million to $1.4 billion due to continued buildout for some large contracts. Accounts receivable increased by $419 million, or 7.8%, to $6 billion. Shareowners equity is up $45.35 million from September, to $5 billion, due to an increase in net income and the increased paid-in capital from recent acquisitions.

Systems for Network Operators
Revenues for the division grew $629 million, an increase of 16.6% over the year ago quarter. Systems for Network Operators represents the largest part of Lucent's businesses. The division experienced higher sales of switching and wireless systems. Growth occurred in Lucent's existing base of Regional Bell Operating Companies (RBOC) and long distance customers as well as with competitive access providers and wireless providers. Doubled sales of data networking systems to service providers, including those provided by Livingston Enterprises.

Among the headlines are the performance of the wireless business and a series of major wins, with several outside the U.S. Lucent signed an $810 million deal with Saudi Telecommunications Company. Other key contracts were sold in Germany and Venezuela. Business has been strengthened in China through sales of optical networking systems. Lucent has also added to the portfolio switching and wireless contracts in Philippines and Taiwan, and optical networking in Japan and Korea. Lucent is absolutely convinced that its commitment to the region will be recognized, and ultimately, rewarded by its customers.

In the United States, Lucent has announced a 5-year strategic agreement with SBC Communications valued at up to $2.4 billion. Lucent will be deploying state of the art switching equipment, including its flagship 5ESS(R)-2000 AnyMedia Switch throughout SBC's seven-state territory. During the quarter, CTR Group selected Lucent to provide land-based optical networking equipment, software and power systems, and professional services for a high capacity global undersea cable network called Project Oxygen. Lucent expects sales of optical networking equipment, network management systems, and other products to reach $1 billion over 4 years.

Bell Atlantic selected Lucent to supply equipment and software for its next generation data package switched long distance network. This is a 5-year agreement worth more than $200 million. Also during the quarter, Lucent announced a 3-year agreement with Sprint PCS for the next phase of its nationwide wireless network, business that could be worth up to $700 million. In addition, Lucent won a $280 million TDMA contract with Telecorp, AT&T Wireless's largest affiliate.

Business Communications Systems
Revenues for the quarter were up $436 million, or 28%, with strong revenue gains both inside and outside the U.S. Revenues were primarily driven by increased sales of Definity systems, messaging systems (including systems provided by the recently acquired Octel), enterprise data networking systems, System X networking systems, and services. Sales outside the U.S. were up about 46%, with increases in all major regions. As sales of data networking systems to enterprise customers expand, Lucent continues to take actions to improve its offering to these customers.

Earlier in July, Lucent announced that it would be acquiring LANNET, a leading supplier of next generation ethernet and ATM switching solutions for local area networks (LANs). LANNET, based in Israel, has a strong market share in Europe, and has distribution agreements and customers throughout the world. With this acquisition, Lucent gains additional data networking strength and a broader global reach.

Microelectronic Products
Revenues were $736 million for the quarter, up 7.1%, driven mainly by sales of customized chips for communications and computing, including components for wireless telephones, local area networks, data networking and high end computer workstations. Lucent also saw higher sales of power systems and other electronic components. Clearly, revenues have been impacted by the continuing softening in the overall markets, particularly in the mass storage disk drive and modem markets. However, Lucent believes that Microelectronics' growth rate is still outpacing industry averages. During the quarter, Lucent announced an alliance with Motorola to develop advanced DSP technology and to cross-license each other's DSP architectures. The alliance gives both companies the ability to deliver next generation DSP faster for a variety of industries including communications, transportation, and consumer electronics.

Three quarters of the way through the year, Lucent has grown revenues by 19.4%, on a continuing operations basis, and increased net income by 53%. Gross margin has grown stronger by 2.9%.

Question and Answer Session

Q: Would you be able to give us a little more insight into the gross margin and its sustainability? What percent of total Lucent revenues are projected to come from the international market in the future? Which geographic are presents the biggest opportunity?

A: The gross margin improvement is not a story about stronger pricing. Instead, the improvement is a mix story. Lucent's mix has been favored by demand pattern in North America for traditional products, but also in wireless and software. Software mix is favorable this quarter: independent software did well, 5E software was just okay. Software can not be pointed to as the driver of gross margins. Core infrastructure strength seems to be delivering it. Lucent expects that demand for Internet and second line demand is sustainable, showing no signs of abating, but Lucent does not expect a steady increase in gross margins.

Lucent has strategic talks underway with all major players around the world. The company is seen as supplier of solutions in a market experiencing the effects of disruptive technologies. Microelectronics already has 50% of its business coming from outside the U.S. and BCS strength internationally is projected to continue.

Lucent would like to maintain balance between the U.S. and non-U.S. markets that reflects the opportunity in the market. 60% of growth opportunity for telecommunications market is outside U.S. Lucent believes that it derives an advantage from the quality of service required for service providers' management of both data and voice networks.

Q: What are international market share goals for the next 5 years in Europe? Who are the toughest competitors? How will Lucent develop profit expectations for Europe? Will acquisitions play a role?

A: Lucent sees a great opportunity to grow market share in EU. Established suppliers exist. Lucent has to bring a different perspective/solution to the marketplace. Convergence and the ability for service providers to offer comparable quality of service for data as customers expect for voice. EU players also have global aspirations. Lucent's portfolio is well positioned to help partners achieve this. Difficult to predict where margins will be. Dependent upon the business mix.

Q: What opportunities exist for Lucent with European wireless, Competitive Local Exchange Carriers (CLECs), and incumbent players? Where has Lucent been successful? Also, why has Lucent been more aggressive on vendor financing?

A: Lucent is late to Europe with GSM, but making progress. The company is making progress with 3rd generation systems, seen as the world leader with CDMA and wide band CDMA. New licenses are up for sale by governments inviting players. Lucent looks to Europe as an opportunity, in view of the global market. Wireless players are typically connected with global players.

With respect to margin vs. vendor financing, Lucent approaches its markets with number of objectives. Gaining the business is one objective, but maintaining profitability is also important. Lucent's philosophy hasn't changed, and the company holds little drawn financing. Some carriers have to build out projects and get some revenue before the market gets the paper. Lucent believes that it is a good judge of project risk. While the markets may not be comfortable with these risks approach, the company sees the balance sheet risk as transitory while pricing concessions would cost Lucent forever. With this informing the company's strategy, Lucent intends to be competitive and to win contracts.

Q: What is Lucent's growth rate in China. Who are the players? How much total [business restructuring] reserve is left and when does expect other reversal decisions?

A: Lucent doesn't give specifics per region. The contracts Lucent has announced clearly signal its transition from vendor role to that of strategic supplier. The business in China is profitable. Local suppliers are becoming more important, but Lucent's main strength is the intellectual property it brings. In terms of growth, China is adding [the equivalent of] one RBOC per year.

The remaining business restructuring balance sits at about $300 million. The projects for restructuring are approximately 85% complete. Lucent expects to utilize the reserve, and its intention is not to reverse it back into income. The company continues to have a philosophy that it will deal with risk and exposure on a current basis. There is no intention to carry forward problems. Lucent is dealing aggressively with any financial exposure, maintaining a solid posture in that regard.

Q: New significant customers added during the quarter. Which new significant customers have been added? What contracts relate to the penetration of existing customers? What is the spending pattern at AT&T?

A: Lucent has had U.S. and non-U.S. wins across the product portfolio. Lucent, with CTR, looks toward being a carrier's carrier, reaching all continents. For its present customers, Lucent's effort toward furthering the depth of its involvement into the data arena is most significant this quarter. Through its ATM and IP announcements, Lucent is showing itself as a data supplier with the ability to grow in networks.

AT&T is still Lucent's largest customer. The relationship is in a state Lucent would like to see continue for a long time, growing as AT&T grows and invests in their network.

Q: To what extent is there demand for the AnyMedia switch from SBC as a data gateway? Can you elaborate on the China strategy with respect to the European competitors on the wireline and wireless sides?

A: SBC will be able to evolve network as traffic evolves. 5E will help to make data switching services available for SBC, enabling the data oriented philosophy.

Lucent's strategy in China is to grow as the market is growing. Currently, the market is undergoing a great deal of reorganization. Services will determine Lucent's revenues. Lucent is not just going with the new kids on the block, and the company has a strong relationship with China Telecom?

Q: Is there leverage going forward for Lucent in the SG&A line?

A: While it will get more difficult, Lucent is not yet at world class cost structure with overheads. The company hasn't taken all of the productivity gains possible in the R&D expenditures. Therefore there still is opportunity.

Q: With respect to BCS, have issues with installing products been resolved? What is a normal level for growth in the international markets? If 40-60% international growth has been helped largely by Octel, what is a normal level?

A: Installation issues were a result of high growth in the December quarter. Lucent has taken actions to improve delivery, and the company does not expect the issue to persist, even with future high growth.

The Definity product is doing well outside the U.S. Messaging opportunities includes Octel capabilities. Data is doing well. Lucent also sees opportunities with developing call center capabilities in Europe and Asia.

Q: Is Network Systems' Central Office switching growing at or above the growth rate for Network Systems? Excluding Octel, at what rate is BCS growing?

A: The Central Office business is a core engine of Lucent's growth, given the nature of demand from added-on lines and longer hold times impacting the network. It is not a drag on results at all.

The BCS growth rate without Octel should range in the mid-teens.

Q:What was the mix of software and hardware for Systems for Network Operators? Was that a driver for margins? Can Lucent leverage (COO Ben Verwaayan's) personal relationships in Europe? Or will Lucent target emerging new entrants for relationships?

A: There are 2 kinds of software in Systems for Network Operators: standalone software and embedded. The independent software sales were very strong this quarter, while the embedded software was weaker due to mix and timing of contracts. Lucent feels there is a reason to be optimistic for software sales potential.

Looking at Europe Lucent feels a better bet would be to look at products and technology rather than relationships. Lucent plans to build relationships with both major and new players.

Q: Is low double-digits or mid-teens more characteristic for BCS, taking out all acquisitions. Noting that Microelectronics growth is under 10%, what is expected for the next couple of quarters?

A: Without considering the contribution from all acquisitions, BCS's growth rate is in the mid-teens. Octel was acquired on October 1, 1997, and it is included in the December quarter. Microelectronics focuses on the communications markets. Lucent is looking for recovery in 1999, and would be disappointed if its growth rate were not double digits next year.

Q:How will Lucent position itself with respect to the 3rd generation issue of backward compatibility? While the contract with SBC creates more data opportunity, doesn't SBC have more negotiating power with its suppliers as well?

A: Looking at the Lucent wireless portfolio, the message is not that Lucent is an advocate of a standard, but rather of solutions. Backward integration is a prerequisite for fast transition to 3rd generation business. Lucent seeks a position to offer service providers maximum potential to leverage past investment. The focus of discussion of the 3rd generation issue has been on the technology, but there is an economic side. With pending pilots, the differences will come closer to resolution. 1 or 2 different solutions are likely to emerge.

The SBC contract pleases Lucent. SBC have shown themselves as more aggressive in their purchasing habits. The opportunity for Lucent to make a profit from this contract comes from Lucent's ability to manage its costs.

Q: Would you please update on the AnyMedia access platform?

A: Lucent is still on schedule for deployment, and the company is constantly adding features. New features are focused more as enablers for service providers to add services for their customers. Lucent's product range gives Lucent's customer's flexibility and the ability to differentiate themselves in the marketplace.

Q: Speculation exists that Lucent must undertake a large acquisition. How do you react to this sentiment?

A: Acquisitions are a tool for the business strategy for the company. Lucent only looks at acquisition in the context of furthering the business strategies. Dilution is an issue in every acquisition. Lucent's goal is shareholder value, and the company sees itself as a strategic buyer. Lucent is interested how companies and technologies play for the long term.

Closing remarks
This has been a very, very good quarter. We don't make predictions, but success this quarter has come from a strong market. The market should continue, as should Lucent's success.

COO Ben Verwaayan has been impressed with the speed of Lucent's ability to develop products, particularly, Bell Labs' products for the data markets. Lucent has a very broad strategy that includes do-it-yourself development, strategic alliances, customer alliances, and acquisition. Lucent has the ability to become a truly global player in a market that wasn't global before. Lucent has just begun to tap the opportunity.

End.