Dueling Fools
Win or Lucent
May 26, 1999

Lucent Bear Argument
By Chris Rugaber ([email protected])

Lucent Technologies' stock has performed stunningly since its spin-off from AT&T in 1996, with an annualized return of approximately 90%. The company has a lot going for it: its research labs have produced Nobel-prize winners in physics, and in 1998 it earned over $30 billion in revenues, far ahead of rivals like Cisco <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %>, at $8.5 billion, and Nortel Networks <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NT)") else Response.Write("(NYSE: NT)") end if %>, at $17.58 billion. But size doesn't necessarily matter when it comes to revenues, especially if a company has cash flow problems, and in recent months it has begun to look as if this telecom Godzilla might have feet of clay.

First, let's consider Lucent's primary business: telecommunications equipment. Unless you've been under a rock recently, or just not reading our website, you know that the Holy Grail of telecommunications is the inevitable "convergence" of voice, data, and video networks. The market for telecom equipment that can reliably transport the broadband digital flow of the not-so-distant future will be huge. The competition for this market is frequently portrayed as winner-take-all, as if Lucent, Cisco, and Nortel are locked into some kind of telecom death match. In the end, of course, it's likely that several companies will benefit.

Nevertheless, some will benefit more than others, and that's what makes investing in a company like Lucent interesting, and risky. Lucent's future is partly dependent on the fortunes of various technologies, such as its Time Division Multiplexing (TDM) telephone network switch, ATM packet switches made by companies such as Ascend, one of Lucent's most recent purchases, and Voice-over-IP (Internet Protocol), the market of which is currently dominated by Cisco. Of course, these are just a few examples.

One of the knocks against Lucent in this fight is that its history and background lie with old telephone technologies, like the TDM switch, and that eventually voice-over-IP and other new technologies will replace them. Of course, Lucent has invested billions to expand its capabilities, including voice-over-IP, and it will be able to sell hundreds of millions of dollars of its current telecom equipment for years before other technologies become dominant, so this may be a bit simplistic.

It's difficult to predict the future of this industry, but investors need to have some kind of understanding of it if they want to know what they're getting into. A good dose of humility would help as well, given the complexity and fast pace of change the telecom world will continue to see in the next few years. The Boring Portfolio made this point well when it sold its shares of Cisco, sparking an interesting debate on its message board.

Even without an in-depth knowledge of the telecommunications equipment industry, simply looking at the ferocious competition ahead should give anyone pause before they buy a company priced at approximately 50 times trailing earnings. In addition to Nortel and Cisco, the Swedish mobile phone company Ericsson is also aggressively moving into this field, purchasing several data networking companies.

And while Lucent is the second largest supplier of Digital Signal Processing (DSP) chips, competition rages there as well, from leading supplier Texas Instruments <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TXN)") else Response.Write("(NYSE: TXN)") end if %>, which has basically re-engineered its entire corporation to focus on DSPs, to a recent Intel-Analog partnership. How many pots is Lucent going to be able to keep boiling at once?

Even worse, the company is marching into all these battles with a sickly balance sheet and negative cash flow. The company spent a lot of cash purchasing 11 businesses in the past 18 months or so, and seems to have lost control of its receivables and inventories.

In the first six months of this fiscal year, the company had negative cash flow from operations of almost $1.5 billion, and spent an additional $1 billion on various capital investments. As a result, while Lucent claimed earnings of $1.8 billion during this period, it was forced to take on over $2.2 billion in additional short and long-term debt, and issued $432 million in additional stock. Using the Rule Maker portfolio's Flow Ratio, Lucent declined from an already scary 1.63 in fiscal 1998 to 2.02 by the end of the second quarter of this year (the Rule Maker portfolio prefers a Flow of 1 or lower; click here for more Rule-Maker analysis of Lucent and Cisco). This change in the Flow Ratio is partly a reflection of the growth in the company's receivables and inventories. Receivables grew from $7 billion at the end of fiscal 1998 to $8.75 billion six months later. The company added only $80 million in cash to its balance sheet during this period, thanks to its borrowing, and as a result, cash comprises only 4.5% of the company's current assets.

Lucent tried to explain at least one source of its accounts receivable troubles in its 1998 10-K: "In return for larger, longer-term purchasing commitments, customers often demand more stringent acceptance criteria, which can also cause revenue recognition delays. Lucent has increasingly provided or arranged long-term financing for customers as a condition to obtain or bid on infrastructure projects." In other words, Lucent doesn't have the power to demand payment schedules that are more to its benefit, so it accepts delayed payments. While this might be defended as an inevitable cost of long-term contracts, it still denies Lucent much-needed cash. And it certainly doesn't explain Lucent's increase in inventories, which jumped 40.6% in the first six months of this fiscal year.

Perhaps that can be explained away as a result of Lucent's recent purchases of other companies, though Lucent's competitors are all buying up companies as well and haven't had this much of a problem. And while we're on the subject of acquisitions, it's worth pointing out that while Cisco buys smaller, easier-to-digest companies, Lucent was forced to make its huge $20 billion purchase of Ascend in order to keep up technologically. How much trouble Lucent will have digesting Ascend remains to be seen.

So, to sum up: investors considering Lucent at this point are looking at a company engaged in ferocious competition in an industry with an exciting but uncertain future, while floundering about financially, with a fairly high valuation. I don't anticipate the 90% share price growth continuing.

Next: The Bull Responds