Lucent: One Step Forward, Two Steps Back

As sales slip, the prospect of profitability recedes further. And more investors are bailing out

The year began on a strong note for Lucent Technologies Inc. (LU ) On Jan. 22, the telecom-equipment maker reported $3.5 billion in revenue for its first fiscal quarter, ended in December. It exceeded Wall Street estimates for the first time in two years, after missing analysts' estimates at least three times during that period. Chief Financial Officer Frank A. D'Amelio predicted revenue for the second fiscal quarter would rise as much as 15%, to about $4 billion, over the previous quarter. The forecast was affirmed by Chief Executive Patricia F. Russo on Feb. 20, and by Chairman Henry B. Schacht on Feb. 26.

Then the Lucent cycle of disappointment began anew. On Mar. 12, Lucent said phone companies had suddenly cut back on orders earlier in the month. It warned that revenues for the second fiscal quarter, ending in March, would rise only 5% to 10%. D'Amelio said the company's return to profitability, which was supposed to take place in fiscal 2002, would "slip" into fiscal 2003. Its shares slid 31%, to an all-time low of $4.30 by Mar. 19, compared with a high of $70 in December, 1999.

Lucent insists it will deliver on its latest promise. Russo vows the company will report a profit in at least one quarter during the company's fiscal 2003, which ends on Sept. 30 of next year. Analyst Paul Sagawa of Sanford C. Bernstein & Co. says Lucent "absolutely" will meet its goal. But others on Wall Street are worried Lucent will come up short again--a development that could hurt its credit rating, raise borrowing costs, and leave the once-proud company vulnerable to a takeover. "We do not believe that gross margins or operating expense cuts will be nearly sufficient to drive this company to profitability in 2002 or 2003," says analyst Ken Leon of ABN Amro Inc.

Despite Lucent's considerable progress in the past 15 months, there's reason to be concerned about its ability to reach profitability in fiscal 2003. Lucent's major customers--the giant phone companies--have cut way back on purchases because they're laden with debt and excess network capacity. Merrill Lynch & Co. expects capital spending on telecom equipment will fall 11% in calendar 2002 and 3% in calendar 2003. That's expected to push down Lucent's revenues some 30% this fiscal year, to $14.8 billion. At the same time, prices on telecom gear have fallen 30% a year in recent times. That's weighing heavily on Lucent's gross margins, which are about 21%--better than the nadir of 11.5% reached in the fourth quarter of last year, but far below the 30% level necessary to put the company into the black.

Not becoming profitable on its 2003 timetable could have serious implications for Lucent. For starters, a poor second quarter means Lucent won't be allowed to spin off its remaining 58% stake in Agere Systems Inc., which makes computer chips and other parts for optical communications systems. Bank covenants require Lucent to post an operating profit before it can distribute stock in Agere to its shareholders. Although that doesn't affect Lucent's cash position, since it doesn't stand to reap anything from the distribution, it would arouse the ire of long-suffering shareholders.

Worse, it could prompt credit-rating agencies to downgrade Lucent. Already, the company's credit rating is in the middle of the junk tier--BB- at Fitch Inc., for example. Delaying the Agere spin-off past June, coupled with the ongoing losses, could push the company's credit rating to the low end of the junk tier. "If Lucent's operating targets are not achieved in the near term, further negative rating actions are likely," Fitch said in a report on Mar. 12. Although the company's liquidity is not a concern, since it doesn't have to repay any substantial long-term debt until 2006, a credit-rating downgrade would raise Lucent's borrowing costs yet again.

That sort of downward spiral could turn Lucent into takeover bait. Last year, the company held merger talks with France's Alcatel, before the deal collapsed at the last moment. Now Lucent's market cap is $15 billion, less than what it was throughout 2001.

Russo is pushing hard to get Lucent back on track. The 49-year-old Trenton (N.J.) native has deep roots at the company, having spent 19 years at AT&T and then Lucent when it became an independent company in 1996. She returned as CEO in November after an eight-month stint as chief operating officer at Eastman Kodak Co. And she has turnaround experience: Before taking her current post, Russo was best known at Lucent for improving the fortunes at the unit that sold communications gear to corporations, now an independent company known as Avaya Inc. "As someone who was with the company and left and came back, I can tell you this is a very different place. Terrific progress has been made," she says.

There's no debate there. Staff cuts under former CEO Henry Schacht have eliminated $2 billion in operating expenses. Capital expenses have been slashed from $1.9 billion in fiscal 2000 to $1.4 billion in 2001, and are expected to hit a maximum of $750 million in 2002. The company reduced its working capital, a measure of accounts receivable and inventory, by $3 billion, beating its target of $2 billion. Schacht also launched new products, which led to the recapture of lost optical share.

Russo says the turnaround will continue even if the markets for telecom equipment don't rebound much. "There's a lot more we can do that will have huge leverage on the bottom line," she says. Russo, D'Amelio, and Robert C. Holder, executive vice-president for product organizations, are meeting with Lucent's other managers to size up prospects for the business through 2003. Based on that review, scheduled to conclude within weeks, they are expected to cut up to 5,000 more jobs, lower capital spending and operating expenses, and possibly sell more assets. They believe those steps will boost margins to about 35%. Execs decline to specify exactly how they will reach that target.

Can they find enough cost cuts to restore the company's profitability during a market downturn? It's doubtful. Leon of ABN Amro thinks Lucent can raise margins to 24% by yearend, based on current market conditions. But to get margins back to the 30s, which is necessary for it to be profitable, Lucent needs an influx of orders from its customers. And a market rebound is nowhere in sight.

Lucent is making progress with some of its new products. The company boosted its share of the optical-equipment market to 18% last year, from 14% in 2000. But the overall optical market shrank 32% last year, to $15.6 billion, and is expected to drop an additional 20%, according to market researcher Dell'Oro Group. In optical switching, one of the only growth segments of that market, Lucent's share is a mere 3%.

Even Lucent's wireless business, the strongest part of the company in recent quarters, is showing signs of weakness. The company is the leading supplier of wireless network gear in North America. But it is No. 4 globally because it lags in Global System for Mobile Communications (GSM) technology, which is the standard in Europe and accounts for 56% of the world's wireless networks, according to Deutsche Bank. More worrisome, U.S. giants AT&T Wireless and Cingular Wireless are switching to GSM gear because it's cheaper. "We are enjoying all the cost savings of having moved into the technological mainstream," says AT&T Wireless CEO John Zeglis.

Lucent's recovery is still some time away. "Right now, this industry is like an endurance race. We are in this for the long run," Russo says. Still, Lucent's inability to return to profitability this year is a serious setback. And if the company can't reach its profit target in 2003, Lucent faces an even more difficult road ahead.

By Steve Rosenbush in New York, with Roger O. Crockett in Chicago

— With assistance by Roger O Crockett

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