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Lucent's Dark Days


Henry B. Schacht has been a busy man since returning to Lucent Technologies Inc. (LU) as chief executive last October. In January, he unveiled plans to consolidate the company's 11 business units into four. Then he eliminated 10,000 jobs, some 9% of the workforce. In February, he won a $6.5 billion line of credit to give the company much-needed cash. The effort is resulting in modest improvement at the deeply trouble telecom-equipment maker. On Apr. 24, the company reported revenues of $5.9 billion for the second fiscal quarter, up 36% from the previous quarter, and a slightly narrower operating loss of $1.8 billion. Its stock rose $1.05 on the news, to $10.25. Turning around Lucent "is a matter of execution and focus," Schacht says. "There's no magic in this. There's no new knowledge required. This is just hard work."

But all of Schacht's hard work may not be enough to save Lucent. While the onetime CEO of Cummins Engine Co. has focused his efforts on fine-tuning Lucent's operations, he may be tinkering with an engine that simply needs to be rebuilt. Schacht's strategy, which he put in place when Lucent was spun off from AT&T Corp. (T) back in 1996, is to emphasize the breadth of the company's products and services, rather than developing cutting-edge products in a few key niches. At the same time, many phone companies are asking for just the opposite. "What we do is buy best-of-breed technology and integrate it ourselves," says Richard G. Ellenberger, chief executive officer of Broadwing Inc., a telecom company in Cincinnati. "It's very difficult for a single equipment maker to be best of breed in every category."

That's not even Lucent's goal. Schacht and other Lucent executives say it's simply not that important to have the best product if you can offer a telephone company a complete communications network as well as services such as installation and maintenance. The evidence suggests otherwise: Many Lucent customers buy key products from its rivals, particularly in the fast-growing markets for optical equipment and Internet routers. For example, local-phone giant Verizon Communications Inc. (VZ), Lucent's largest customer, buys its routers from Cisco Systems Inc. (CSCO) and others. Without competitive products in key areas, Lucent is in jeopardy of losing its status as the top supplier of communications gear in the U.S. "Lucent is likely to fall from its No. 1 position to third or fourth by the end of 2001," says analyst Steven D. Levy of Lehman Brothers Inc.

Certainly, Lucent's problems go well beyond its soup-to-nuts strategy. Under former CEO Richard A. McGinn, it used questionable accounting practices and aggressive lending to customers to try to meet its 20% revenue growth target. When the tactics backfired, Lucent's stock plummeted, and McGinn was ousted last fall. About the same time, telecom companies started running into financial trouble and started cutting back on their purchases from Lucent as well as rivals Cisco and Nortel Networks Corp. (NT) Just this month, one of Lucent's big customers, WinStar Communications Inc. (WCII), filed for bankruptcy protection, owing Lucent $700 million that it may never pay back.

The avalanche of troubles could mean the end of Lucent, a once-proud company that traces its lineage to the inventor of the telephone, Alexander Graham Bell. Its shares have dropped 85% from its 52-week high of $67 and are barely above the offering price of $7 when Lucent was spun off from AT&T in 1996. While the February credit line will keep the company out of bankruptcy for the foreseeable future, Lucent's market cap has sunk so low, to $30 billion, that it could be taken over or sold in pieces to rivals, such as Germany's Siemens (SMAWY) or France's Alcatel (ALA). "We continue to believe that a breakup or merger remain distinct possibilities," says Tom Lauria, telecommunications-equipment analyst at ING Barings LLC. Schacht wouldn't comment on takeover speculation, but says Lucent can survive on its own. Even though it's burning cash at a fierce rate, he says bankruptcy can be avoided through asset sales and cost cutting.

Just as Lucent is fighting for its life, the company is constrained by the lack of a strong, permanent CEO. Schacht, who ran the company from 1996 to 1997, agreed to return on a temporary basis after the board fired his protege, McGinn. Trouble is, after six months the board can't find a suitable candidate willing to take the job. Former General Electric Co. (GE) executive W. James McNerney Jr. was approached about the post several months ago, according to J.P. Morgan Chase & Co. analyst Gregory S. Geiling. But the highly regarded executive decided to run 3M Co. instead. Another candidate, former Nortel executive F. William Conner, also chose a different job--the helm of Net security upstart Entrust Technologies Inc. (ENTU) Now board members are targeting Krish Prabhu, chief operating officer at Alcatel, according to one Wall Street analyst and another source close to the situation. Prabhu could not be reached for comment. Investors think speed is of the essence. "People aren't really paying that much attention to second-quarter numbers. They want to know who the next CEO is going to be," says Jeffrey Heil, director of equity investments for the Regents of the University of California, which sold almost all of its Lucent shares in March.

Schacht insists that Lucent's leadership is strong. He says the company is more closely managed now than it was during the McGinn era. For example, his core management team meets every Monday and Friday, compared with once a month for McGinn's group. He would not comment on the potential candidates and says there is no fixed timetable for finding a new CEO. "I do not view myself as interim," he says. "We have put together a plan and a program to which everybody is fully committed, and we're in the process of executing, and there's total concentration."

And rather than being a problem, Schacht insists that Lucent's strategy is a competitive advantage. He predicts that the makers of one or two hot products, such as CIENA Corp. (CIEN) in optical gear, will falter eventually, even if they do well in the short term. "There is a debate in the industry: Are you better off focusing on one single segment of the industry?" says Schacht. "But what does CIENA do when it fills up demand for hot boxes that have a short shelf life? I think the long-term survivors will be companies that provide a range of service to big [telephone] carriers."

Lucent also insists its products are just fine. It won't report revenues by segment, but it points to rising sales of speedy digital subscriber line equipment and a $5 billion wireless deal from Verizon in March. In April, Deutsche Telekom (DT) ordered an undisclosed amount of optical equipment for a multinational network. "Throughout our lineup, we are moving resources to next-generation products," says Executive Vice-President William T. O'Shea.

Time, Schacht figures, is on his side. The troubles in the telecom industry will trigger the bankruptcies of many upstarts and widespread consolidation among the remaining players. The survivors are likely to be Verizon and the other local phone giants, who happen to be Lucent's best customers. "We stand to benefit in a consolidating market," Schacht says.

LOOMING LAYOFFS? Schacht has much work to do to prove he's right. Lucent has been losing money since last September and is expected to continue to bleed red ink for the rest of this year. In the latest quarter, the company's gross margins were 17%, down from 49% two years ago. By contrast, Nortel's margins in its latest quarter were 30%. Lauria thinks Lucent may have to lay off 10,000 more employees to get its cost structure in line. At the same time, Lucent's cash balance dropped to $1.4 billion in the latest quarter, down from $3.8 billion three months earlier. To stay afloat, the company has been selling off assets. It expects to complete an auction for its fiber-optic-cable manufacturing business and raise another $5 billion or so in the next few weeks.

Any change in strategy may have to wait for a new chief. Rivals say Lucent's current approach won't work unless it has top-of-the-line gear to complement its product breadth and support services. "What we found is that most carriers are looking for best-of-breed solutions," says Hugh Martin, CEO of optical upstart ONI Systems (ONIS). Other industry experts agree. "This industry is about great products," says Vinod Khosla, a general partner at venture-capital firm Kleiner, Perkins, Caufield & Byers, who has backed Lucent rivals Juniper and Corvis. "If you don't have them, you don't get anywhere. And for a long time, Lucent has been coasting on older products."

Yet developing new technologies may be particularly difficult for Lucent these days. The cost-cutting measures of the past few months could hurt its long-term product development. The budget for research and development fell to 17% of total revenues in the latest quarter, from 22% just three months earlier. And analysts expect R&D to drop to 15% of sales by the end of September. By comparison, Nortel's R&D budget was 13% of sales last year, even while analysts believe it did a better job of developing crucial new technologies. Lucent says it's simply returning to its historic spending levels of 12%.

Even before the cuts, the company was having a hard time getting the right products to market at the right time. For example, carriers are currently buying a switch that uses optical and electrical signals to transport voice and data. But Lucent has pretty much ceded the market to CIENA. The upstart will sell an estimated $170 million worth of switches this year, according to Merrill Lynch & Co., and that will rise to about $500 million in 2004.

Lucent has developed a pioneering all-optical switch, called the LambdaRouter. While Global Crossing (GX) and several other unnamed carriers are testing the switch, there hasn't been a single sale. Jeong Kim, the new president of Lucent's optical-networking group, says demand for the LambdaRouter will take off later this year and in 2002. But customers disagree. Verizon says it will be at least several years before a market develops. "We don't have the LambdaRouter on our radar right now," says Paul A. Lacouture, president of Verizon's network-services group.

A few years ago, it might have been possible for a single company to be a soup-to-nuts supplier. But in an age of digital convergence, it's proving nearly impossible for one carrier to master it all, from optical and data networking to wireless and voice switching. It may take a new CEO before Lucent figures that out. By Steve Rosenbush in New York with Amy Borrus in Washington


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