Notes and Observations
Lucent Technologies, Inc.
9 Months ended June 30, 2004
please see Disclaimer at bottom of report
This report was last amended on November 17, 2004. Amendment was for corrections of 2003 altman z calculations
Lucent Technologies, Inc., designs and delivers networks for the world’s largest communications service providers. The reportable segments are Integrated Network Solutions (“INS”), Mobility Solutions (“Mobility”) and Lucent Worldwide Services (“Services”). The INS segment provides a broad range of software and wireline equipment related to voice networking (primarily consisting of switching products, which Lucent, sometimes refer to as convergence solutions, and voice messaging products), data and network management (primarily consisting of access and related data networking equipment and operating support software) and optical networking. The Mobility segment provides software and wireless equipment to support radio access and core networks. The Services segment is a worldwide services organization that provides deployment, maintenance and professional services in support of Lucent’s own product offerings as well as multi-vendor networks.
Notes and observations
1. Lucent has once again become a technological competitor. During the late 1990’s and early 2000’s, they did lose their technological edge. This loss was caused by internal fraud, engineer defection, increased competition and technological disruption. Lucent is known as the leader in supplying Wireless Service Providers with CDMA infrastructure. Verizon Wireless is their largest wireless customer. Lucent strategically decided to abandon GSM network builds in 2001/2002. This was a controversial decision, since GSM was the prevalent system in Europe. CDMA is the alternative to GSM. The mass penetration and growth of CDMA is occurring. Over the last year or so, GSM companies, such as ATT Wireless and Cingular, have given serious consideration in upgrading their networks to UMTS. UMTS gives GSM systems, the benefits of 3G and CDMA operations. UMTS uses WCDMA technology.
2. Competition and disruption is always a concern for any developer of communications infrastructure. Lucent has unusual and company specific, competitive concerns due to their retired labor force and associated retirement benefits. Lucent has what is called “legacy costs”. These legacy costs are primarily benefits that need to be paid to retirees. These costs need to be built into their projects and “Requests For Proposals” (RFP). Competitors do not have such legacy costs, and hence can bid on jobs in a less expensive manner, at the same time still retain greater profitability. Lucent also is contending with several companies from China. These companies, have lower costs and certainly a qualified “brain trust”. Up until a year or so ago, China was regarded as telecom copy-cats. These companies were known to have technology copied from the likes of Lucent, yet without the technological quality. Many argue that these companies from China currently now have leading technology, and of course their costs are much lower. Two of the leading Asian competitors of Lucent are Huawei and ZTE.
3. In F2003 ATT, BellSouth, SBC, Verizon and Verizon Wireless contributed 22% of Lucent revenues. Customer concentration does produce greater risks.
4. There has been a historical general rule of thumb that Service providers spend 10% – 20% of their revenues on capital expenditures. These capital expenditures include line maintenance, warehousing, rental or purchase of real estate, and infrastructure upgrades (switches, routers, routes, etc). Data and voice networkers, such as Lucent claim that they receive about 50% of that allocation. Of that remaining 50%, being very liberal in rounding off the allocation, you can say that ½ goes to wireless and ½ goes to wireline (both voice and data, but that is now being converged into one). When trying to monitor capex from service providers, I generally use 10% – 15% of revenues. Of course it is difficult to monitor, but it helps to have an understanding of this historic trend.
5. Corporate insiders have not been selling many shares for the last couple of years. Pat Russo , CB owns 2,017,963 shares, Henry Schacht owns 1,088,014. Frank D’amelio CFO owns 346,518. Assorted other officers own in the area of 3,000,000 shares. In general, insiders own less than 2% of the available common stock.
6. The telecom market entered a depression during mid 2000, which continued through 2003. It appears as though the decline in spending has ceased. Unlike the mid 1990’s of high double digit spending growth, most companies are forecasting mid single digit growth. CFO, D’amelio, recently claimed that Lucent is quite happy with single digit growth, whereas in the past they would have been extremely disappointed with such lackluster growth. Lucent once had revenues in excess of $30B. They now do on average around $2.2B per quarter. Lucent’s breakeven seems to now be in the area of $2.1B. Nortel (a competitor) issued a revenue warning on September 16, 2004. In that warning they discussed the expected growth of mid single digits.
7. Service Providers are expected to spend as little as possible in their infrastructure over the next few years. One type of spending will be to save money over the long term. This can be done in network upgrades, be it wireless or wireline. The other type of spending will be done, to avoid losing customers to their competition. In the past, Service Providers would spend for the sake of claiming to have the most efficient network.
8. Certain industry segments are growing faster than others. Voice and circuit switching is a dying breed, as the telecom is moving to converge both voice and data over IP (internet protocol) systems. The largest growth is expected to be in VoIP gateways. I have seen projections of 30 – 50% CAGR in that area. Lucent has been a weak force in VoIP. They recently purchased a company called Telica. Supposedly is strong in the VoIP area. There has yet to be any contract announcements from the Telica acquisition. There is speculation that Telica already existed in Verizon’s network. Lucent hinted at analyst day a few weeks ago, that a contract with a major carrier would be announced at some point. Lucent claims that the RFP process of a VoIP network is slow, and hence investors need patience.
9. Lucent does offer an end to end service. They develop the software, the equipment (generally via OEMs, outsourcing or via Joint Ventures), offer the services, and have compatibility with other vendors. This end to end service is becoming more valuable as the Service Provider networks are downsized, more complicated and cost controls and profitability of providers are looked at much closer today, as opposed to the late and mid 1990’s.
1. Industry leader in CDMA. This is important as wireless companies around the world begin to build or upgrade their networks.
2. They have excellent position in China, India and Eastern Europe.
3. Strong strategic partners such as Juniper.
4. Balance sheet is getting stronger. Lucent debt was recently upgraded by Moody’s. Debt is still lower grade, nevertheless the picture is improving. Debt has been upgraded to B2 (highly speculative) from Caa1 (Substantial risk). Here is a link on our site, which has a table on debt ratings.
5. Cost reductions, debt buybacks and stabilizing revenues have helped make Lucent a stronger company. Unlike mid 2002, they do not appear to be an immediate or imminent bankruptcy contender. Here is a link on our site, where we discussed the deterioration of Lucent bonds during 2002. Lucent short term bonds were selling for nearly $0.30 per share. The same bonds are now trading over par.
6. Lucent has been consistent with their strategies over the last 3 years. They recognized and openly discussed their solvency issues. They laid out a game plan of restructuring and goal of liquidity. So far they have achieved those goals. More recently they have laid out a framework for continued profitability. Here is a link of ours, which details much of Lucent’s financial history since 2001.
7. Lucent is one of many companies that were harmed in the telecom depression. I can’t think of one competitor that has not gone through the same magnitude of pain. Even Cisco lost nearly 75% of her market cap during the slowdown. Cisco is not a fair example, as they are not really providers of end to end networks, nor do they have a great presence with the Service Providers.
8. Cash flow from operations, not only exists, it also seems to be improving.
9. Lucent bought back or recapitalized over $2.2B in debt since the fiscal fourth quarter of 2002. Fixed charges will be reduced by about $150M due to this.
10. Lucent Worldwide Services (LWS) is a rather new division of Lucent. Margins are less than Mobility Solutions and INS. Nevertheless, Lucent claims that LWS gives Lucent the ability to enter a network, which Lucent does not currently have a presence in , and in turn over time, gives Lucent the ability to enter that network in other areas. Some of these areas could be optical switches, bay stations, multiplexers, DSL deployments, etc.
11. Lucent took a charge to their deferred tax asset during 3Q02. This was done in accordance with SFAS 109. There has been recent industry talk that Lucent will be able to bring this asset on the balance sheet again. The prior write off was in excess of $5B. If the valuation allowance was materially reduced, Lucent would once again have a positive tangible book value.
12. Lucent recently announced that they have been approved for a tax refund in the area of $1B (including interest). Lucent previously recorded a receivable of $139M. A $1B unanticipated inflow, will be quite positive for Lucent.
1. Circuit switching is declining quickly. Keep in mind that Lucent has been recognizing this since as early as 2001.
2. Balance Sheet is still leveraged, although a lot cleaner than it was several years ago.
3. Quality of earnings is an issue. Pension credits are responsible for the recent reporting of quarterly net income. If pension credits were eliminated, Lucent would very conceivably still be reporting losses. Pension credits are expected to permanently disappear during the next 18 months.
4. Legacy issues from retirees continue. This is costly in both dollars and job profitability. Lucent has previously funded these costs with a trust set up by AT&T prior to the Lucent spin-off. This trust is expected to disappear within the next 18 months, and unless renegotiated, Lucent will have to fund out of operations. Lucent is in the midst of discussing and negotiating these issues with the Union. You can read up on this at www.lucent.com . You can also read the retiree’s perspective at www.lucentretirees.org .
5. Although the debt was reduced by over $2.2B since Fiscal 4th quarter 2002, this did not come without a price. Lucent not only paid cash to reduce debt, but also issued 623M common shares. The following is a table of fully diluted weighted shares outstanding.
1. Concentration of a few customers.
2. Concentration of wireless revenues. Wireless revenues make up 45% of total revenues and have higher gross profits versus optical infrastructure, INS and Services. To Lucent’s credit, they do recognize and bring this to shareholder’s attention. Lucent claims that their projections and guidance include the lower gross profit items. Lucent also contends that their disappearing pension credits, have also been considered in their guidance.
3. Wireless portfolio is concentrated in CDMA. Lucent has yet to recognize revenue in the US with UMTS. Lucent recently announced their first international UMTS deployment with ZAPP in Romania. Lucent has no presence in GSM networks. Lucent has avoided and exited the GSM networks. Lucent would be hurt incredibly if CDMA was disrupted.
4. I mentioned Cisco as having a limited presence in the Service Provider market as well as currently lacking an end to end solution for Service Providers. This could change quickly, if Cisco were to make an acquisition.
5. Lucent previously lacked a VoIP solution. Verizon gave Nortel the opportunity to fit them with a VoIP deployment. To Lucent’s benefit, this is not an exclusive contract and the duration is 18 months. The contract was entered into during the 4th calendar quarter of 2003. It is hoped that Lucent’s Telica acquisition will not only fill the VoIP void, but also, get Lucent to have a material presence in Verizon’s VoIP network.
6. Of course risks include another period of severe or even moderate telecom spending slowdown.
7. Please look at attached Altman Z spreadsheet. Altman Z is a solvency predictor. You can see my spreadsheet, at my site, which explains the use of the spreadsheet altmanzscoretemplate.xls In the attached Altman Z handout , I made certain assumptions. They are as follows:
a. Retained earnings of $1B. This is an extrapolated and unsubstantiated number. I have included the $1B tax and interest refund, as well as including an anticipated deferred tax asset of $4B being put back on the balance sheet. If both were added to the current deficit, retained earnings would be greater than $1B. I just preferred using $1B. One could easily argue that Lucent should not be awarded any positive retained earnings. The only way Altman Z could be applied with any relevancy would be via positive retained earnings.
b. Retained earnings is currently a deficit of ($3,064)
An interesting observation is that Altman Z for Lucent is computing to 2.51. According to the spreadsheet, that number indicates that there is a “high ” chance of bankruptcy. What is most interesting to me is that when I previously ran this spreadsheet, the number was producing a result of 1.41 on September 30, 2003, which is a “very high” chance of bankruptcy. Of course, this is only a slight guide, but at the same time, it shows improvement in the operations and financial stability of the company.
Please understand that accompanied spreadsheet is merely a “what-if” analysis for discussion purposes only
1. Revenues to grow at an annual rate for an extended period of 6 to 10%. Lucent has guided at “mid-single digits” for 2004 only. Lucent has not offered forward guidance.
2. Gross Margins of 40%. Lucent has guided “from the high 30’s to the low 40’s in the near term”.
3. Quarterly operating expenses of $700M. I am using the same as Lucent guidance. Lucent has stated that their mid-term goal is to achieve net margins of 10 to 15%.
4. Tax rate of 35% starting in F2005, based on the anticipation of the deferred tax asset of around $4B entering the Balance Sheet.
5. Please understand that our financial model is “raw”, subject to material error, and is not based on current company guidance of any sort. We use such models as a “financial road map”
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