Brain Drain, Payment Worries Could Lash a Post-McGinn Lucent

After free falling for months, Lucent (LU Quote) Monday read the writing on the Wall Street and decreed that Chairman and CEO Rich McGinn depart.

Tailspin Lucent pounded on recent warning

Lucent's troubles, however, aren't likely to leave with McGinn. During McGinn's three-year tenure at least two significant fractures opened in Lucent's foundation, owing to the company's failure to attract scarce engineering talent and its decision to extend favorable payment terms to customers. Insiders say those problems, which arose from McGinn's focus on impressing Wall Street and grew worse as he failed to confront the results of his decisions, are likely to hamstring the company long after McGinn and his immediate replacement, former Lucent head Henry Schacht, are gone.

Now, with the stock having lost three-quarters of its value this year and earnings expectations cut drastically, two questions loom: Can Lucent recover lost ground in the optical networking race, where it has ceded a huge lead to rival Nortel (NT Quote)? And will the company have the financial wherewithal to cover the $7.7 billion in loans it has agreed to provide and the $1.3 billion its customers have already tapped? Lucent shares slipped 56 cents Monday to $22.06.

Belt Loops

The problems began a year ago, insiders say, when Lucent sought to tighten its belt with a hiring freeze of sorts. This move came at a time when Nortel was gearing up a tremendous optical networking product line that gave it a lead in a lucrative new sector in which Lucent has mostly failed to compete.

Lucent engineers, particularly in the optics division, called the hiring cap a poorly thought-out, poorly timed move that handcuffed the company when engineering talent was needed the most. For its part, Lucent says it never stopped hiring "key" talent and adds that the hiring switch was more of a "pause" because the company hired 3,000 cheaper, inexperienced college recruits during that period.

Giving It Back Lucent's retreat wipes out years of gains

Former insiders have criticized McGinn for trying to curry favor with Wall Street at the expense of operations. These people saw a hiring cap as an attempt to appease the Street by attacking perceived corporate bloat. But the move hurt Lucent by keeping it from hiring much sought-after engineers, and the stock price plunged this year when the company's shortcomings in optical equipment began pressuring earnings growth, leading to repeated shortfalls. Essentially, say insiders and observers, Lucent dropped the ball and Nortel ran with it.

"I know quite a few people will be happy now that he's gone," one former Bell Labs optical scientist says of McGinn. "There were some wrong decisions made that let Nortel take over," adds the scientist, who now serves as a consultant to Lucent and who asked not to be identified.

Into that hollowed-out, dispirited organization will walk the new CEO. Most analysts say Lucent will come out of its reorganization with low enough earnings expectations to give the appearance that it has regained its footing. But it is not clear whether there will be a strong enough team in areas like optical equipment to stage a strong comeback anytime soon.

The Overhang

What's worse, the new Lucent still carries McGinn's legacy of vendor financing. Lucent's stumbles put it at a disadvantage to Nortel, which observers say meant it had to rely on favorable financing deals to push sales.

Schacht returns

One example of the danger of this financing could be ICG Communications (ICGX Quote), the financially troubled phone and data network service provider. It has a $250 million credit agreement with Lucent, under which ICG is committed to buy at least $175 million of equipment. ICG declined to say how much of the Lucent money it has tapped. Those numbers would be part of its third-quarter financial report, which isn't yet complete.

Lucent had $1.3 billion of financing already on its books as of July, and it's uncertain whether more has been added to that. With a funding squeeze across the telecommunications sector, the once willy-nilly financing policy could come back to haunt Lucent with a vengeance. Lucent doesn't offer details of its financing activities.

But clearly ICG is teetering -- its stock traded recently at 44 cents, off a high of $39.25 -- and it is only one of the scores of telecom start-ups and Lucent customers that have been squeezed by the recent downturn in the stock market. Lucent said earlier this month that it has already had to move money into its reserves to cover possible nonpayments.

Lucent plans to address vendor financing, along with other matters, in its call with analysts later Monday. The company has been working with Citibank to create a special purpose trust to get a lot of the debt off its books. Lucent says vendor financing is common to the industry and that most of its sales don't involve lending money to its buyers.

But when you've cut earnings forecasts five quarters running, credibility can take a hit. Investors will be looking closely at vendor-financing issues as the telecom sector's ailments continue to weigh on these stocks.

"There is a thought that if one goes, a domino thing can start happening," says Don Luskin, manager of OpenFund, referring to Lucent's cash-strapped customers. "There is a tremendous risk in that," says Luskin, who owns no Lucent and has a small position in Nortel.

Investors, now wise to putting more weight on what Lucent does more than on what it says, are leery that more bad news awaits.