Lucent: One Step Forward, Two Steps Back

The year began on a strong note for Lucent Technologies. On Jan 22, the
telecom-equipment maker reported $3.5 bn 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 bn 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.

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. 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.

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 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. 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. 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. 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. 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.
"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%.

Can they find enough cost cuts to restore the company’s profitability
during a market downturn? It’s doubtful. 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. 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, US giants AT&T
Wireless and Cingular Wireless are switching to GSM gear because it’s cheaper.

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 in BusinessWeek. Copyright 2002 by The McGraw-Hill Companies, Inc