Lucent: Diamond in the Rough or Lump of Coal?

What's Lucent Technologies(LU Quote) worth? That's an important question to the millions of investors who own the stock and are wondering whether to hold or dump their shares. Thanks to its former ties with AT&T(T Quote), Lucent is still one of the most widely owned U.S. equities. And it's important to millions of other investors who are trying to figure out if this is a potentially profitable value play or a stock to avoid at any price.

You can find just about any number you want on Lucent's value -- which is, of course, no help at all. On Wall Street, 16 analysts rate the stock a buy, one gives it a sell and 15 call it a hold, whatever that means. I've found a target price as high as $30 a share from Banc of America Securities, and yet Alcatel, which got to know the inside dirt on Lucent while negotiating to buy the company, decided $6.90 a share was too much to pay without clear control of the joint board of directors. The stock market, on the other hand, pushed the shares up to $8.54 on June 5 on news that the soon-to-close June quarter wasn't going to be any more of a disaster than expected.

Before I add more numbers to the soup, let me try to explain why the numbers are so confusing right now. Currently, I think it's possible to put a target price on Lucent as either a value stock or a growth stock -- and the two methods focus on very different questions about Lucent's future and produce radically different prices for the shares.

If you analyze Lucent as a value stock, you're focusing on the ability of the current management to carry out the draconian cost-cutting measures it has outlined and to find $2 billion in cash by September. The issues for Lucent as a value stock are relatively straightforward and short term. If you think management can pull off this task, the stock is worth $12 to $15 a share. And, of course, if management can't walk the walk, then Lucent will violate the terms of its bank loans and other debt and wind up worth less than its April 4 low of $5.50 a share. But in either case, we'll know the answer in the short term, certainly within six months.

If you analyze Lucent as a growth stock, however, you're focused on what happens after management pulls off a short-term turnaround. Looking at the collection of businesses that Lucent will have left after selling its enterprise, chip and fiber-optic divisions, will Lucent have enough in-demand products to generate significant earnings growth in 2002 and after? If Lucent can show convincing evidence of the potential for 10% or 15% growth, then yes, it could be a $30 stock in a year. In the absence of that kind of growth, however, I wouldn't expect the turnaround valuation of $12 to $15 to hold. Instead of marking a milestone on Lucent's road to recovery, that price could stand as the peak that leads to a steady decline as disappointed investors give up on the shares.

OK, now that I've established a general price range for "Lucent the value stock" and "Lucent the growth stock," let's take a look at how likely Lucent is to meet either set of goals.

Lucent as a Value Stock

Here's a checklist of what, in my opinion, Lucent has to accomplish by September to earn a $15-a-share price: sell its optical unit for $2 billion or more, cut 10,000 employees, clean up the balance sheet by reducing inventory and writing off more bad debts from troubled customers, and stabilize gross margins above 20%. And, finally, hire a new CEO who can lead the company once the cost-cutting stage is finished.

That's not an impossible list to work through in a few months. The problem, however, is that Lucent hasn't made much progress on these goals over the past few months. Thanks to the distractions of the Alcatel deal, for example, Lucent doesn't seem to be any closer to selling its optical unit than it was two months ago -- and in that time, the number of potential buyers for the unit has declined and the likely price has shrunk from $4 billion to $2 billion.

Same on the job-cut front. Lucent announced back in January that it would cut 10,000 jobs. By the end of April, the company had managed to reduce its workforce by only 2,000. Inventory reductions have been just as slow to materialize. Lucent had more than $1 billion in inventory on its balance sheets at the end of December. Lehman Brothers calculates that the company wrote off more than $800 million during the March quarter but still managed to reduce inventory by less than only $300 million as unsold products and components continued to pile up.

And the bad news about loans to deadbeat customers hasn't come to an end yet, either. At the beginning of June, for instance, investors learned that Lucent was on the hook for $300 million lent to One.Tel, a currently insolvent Australian phone company, so it could buy gear from Lucent.

My estimate is that Lucent will get enough done, though just barely, to keep the wolves from the door, but not enough to signal a successful turnaround. By September, $10 a share is likely under those circumstances, while $12 is a possibility, but $15 seems a very long shot.

Lucent as a Growth Stock

If I'm wrong and Lucent climbs to $15 by September, I think anyone who owns the stock should give serious thought to selling these shares. The growth story at Lucent is absolutely dismal over the next 18 months.

Here's the problem: After spinning off or selling its enterprise business Avaya (AV Quote), its chip business Agere Systems, and its fiber-optics unit this fall, Lucent will be left with a core business selling equipment to telecom service providers. Lucent's current product line in this area has been losing market share to competitors. And new products that could get growth moving again are a good year to two years away from making a difference.

Take Lucent's current position in the optical systems market. In the fourth quarter of 1999, according to Robertson Stephens, Lucent controlled 22% of that market. In the fourth quarter of 2000, that share had declined to just 9.4%, the investment firm estimates. It doesn't matter whether you look at legacy equipment, such as gear built for the older SONET standard (Lucent's market share for this segment dropped from 19.3% to 9.6%) or the newer DWDM (dense wave division multiplexing) gear (market share for this segment dropped from 29.7% to 9.2%), the picture is the same. Lucent is losing sales to rivals, and that is especially damaging at a time when growth in the entire telecommunications equipment market has slowed.

I don't think you have to look very hard to figure out why this has happened: Lucent took its eye off the ball and failed to deliver new products on schedule. This is exactly what happened in the market for ATM multiservice switches, a market that Lucent used to lead thanks to its acquisition of Ascend Communications. But newer switches from Nortel(NT Quote) and Alcatel have been gaining momentum; Lucent's market share dropped 3 percentage points from December 1999 to December 2000, and Lucent won't have an update for its GX550 switch until the fourth quarter of 2001.

This isn't to say that Lucent doesn't have any new products, but unfortunately they're clustered in troubled market segments. Lucent's lineup for the next generation of wireless networks (called "3G" for third generation) looks extremely strong -- but unfortunately the company has almost no presence in Europe, where the 3G buildout will kick off. In North America, where the company has a chance to rack up good sales, the buildout isn't expected until 2003-2004. Lucent also has a strong DSL (digital subscriber line) product line where its Stinger DSL platform looks like a winner. But the DSL market has been among the hardest hit by the failure of start-up telecommunications providers, and growth in this market has dropped off a cliff, with recovery not to begin until late 2002.

At this point, given slow growth in Lucent's core market, the company's loss of market share and the relative weakness of its new product lineup, I'd have to agree with those analysts who don't see Lucent showing quarterly revenue levels above those of 2000 until the September quarter of 2002. And even then, growth is likely to be anemic: Robertson Stephens estimates that Lucent's September 2002 quarterly revenue will be just 3% above revenue for the September 2000 quarter.

I just don't see a reason to own Lucent as a growth stock when so many telecommunications equipment stocks with better growth prospects over the next 18 months -- Cisco (CSCO Quote) and Nortel come to mind -- are trading at similarly crushed prices. And I certainly don't see any justification for believing this stock is worth more than its $10 to $15 a share turnaround value. Instead it's likely, in my opinion, that when investors actually focus on Lucent's growth problems the shares will retreat from that value stock peak.

I find this conclusion rather ironic. Value investors, usually characterized as long-term investors willing to wait years for a return, might find Lucent attractive as a short-term turnaround play. Growth investors, usually said to have much shorter time horizons, shouldn't be counting on time to bail out this damaged stock.

In my next column, I'll take a look at three stocks with much better growth potential that should do well even if the general economy turns out weaker than we expect in the second half of 2001.