The Wall Street Journal - October 25, 2004

 

Less May Be More

By SHAWN YOUNG
Staff Reporter of THE WALL STREET JOURNAL
October 25, 2004; Page R10

Executives at Lucent Technologies Inc. have decided that the best way for the company to grow is for it to shrink.

After slashing itself to the bone just to survive, the nation's biggest maker of telecommunications equipment hopes to get back on the expansion track as a more focused, more efficient company.

The payroll has been cut to 32,000 from a high of 157,000 in 2000. Lucent has hacked off entire lines of operation, and sold, shuttered or spun off 27 of the 40 businesses it had bought since 1996. At one point, executives even ordered every third light bulb in the company's offices unscrewed, to dramatize to employees the need to cut costs.

"They have had to cut and cut hard," says Paul Sawaga, an analyst at investment-banking firm Sanford C. Bernstein & Co. in New York. "Now we get to see if the cuts they made were the right ones or not."

Lucent has a lot of company in the ranks of businesses that have had to sharply narrow their goals and operations in order to regain their footing, or simply to survive. Last year, for example, DuPont Co. sold its textile unit. Lucent's competitors, including Nortel Networks Corp. and Tellabs Inc., also have had to shrink to survive. In one of the most recent examples, Gateway Inc. has retrenched, dropping efforts to prop up shrinking revenue with sales of digital cameras and other consumer electronics; the company is focusing instead on its core personal-computer business.

Lucent stands out because its restructuring has been so extensive and so wrenching. Now it has reached the point, says Chairwoman and Chief Executive Patricia Russo, where a return to revenue growth is critical.

"The way you create value for shareholders is you continue to improve your earnings," Ms. Russo says. "One way to do that is to cut your way to improvement, but that is not a long-term sustainable model. You've got to have some top-line growth."

Back From the Brink

The outlook is improving. Lucent last week reported that revenue grew 7% in fiscal 2004, which ended Sept. 30. That was its first full-year growth in four years. The company has now notched five straight quarters of profit, after a 13-quarter string of losses. Its share price, which soared to a split-adjusted high of $62 in 1999 and sank below $1 in 2002, has been around $3.40 lately.

The modesty of the company's recent growth and share price are in marked contrast to the promise of its heyday, during the technology-driven stock market boom of the 1990s. As demand for Internet gear soared during the boom, Lucent officials made a goal of 20% revenue growth a year the centerpiece of the company's strategy.

Lucent's approach was a common one in such heady times, but even in more sober environments many companies overreach. "The tendency of most businesspeople is to say, 'We'll grow our way out of our problems,' says Gerald Faulhaber, a professor at the University of Pennsylvania's Wharton School. Top executives in particular get mesmerized by having bigger companies, more extensive businesses, more employees, he says. "People forget that what you're in business for is to make money, not to get bigger."

Lucent's troubles began in 2000, as sales sputtered. In response, the company promised generous discounts on future purchases for customers who stayed on board. But by the end of 2000, customer orders were evaporating fast, and the discount pledges further compromised revenue.

Lucent's practice of lending some customers the money to buy its gear also backfired. Lucent financed so many customers that by 2001, the company had run up $7.5 billion in such loans. When the customers -- many of them start-ups -- began crashing, they contributed to a balance-sheet crisis at Lucent so severe it led some investors to fear that the company might be forced into bankruptcy protection in 2001.

Lucent avoided that fate, but it was in deep trouble. Manic growth had fostered internal practices that pushed the company's costs out of control. Officials divided the company into 11 segments during the boom years, each unit striving to move as fast and be as specialized as new rivals a fraction of Lucent's size. And lavish spending on research, some of it far-fetched, was a longstanding, even proud, tradition at Lucent's fabled Bell Labs research arm.

Scrambling to Survive

When the tech bubble burst, Lucent's bloated costs left no time for a soft landing.

"We got after the business on every level we could think of," says Chief Financial Officer Frank D'Amelio. That ranged from shoring up the balance sheet, to ending dividend payments on the company's stock, to taking a fresh look at what Lucent should be trying to do -- and not do.

The first high-profile paring came in 2000. Lucent spun off Avaya Inc., which makes gear for sending business calls through data networks. Then, under intense financial pressure in 2002, Lucent spun off Agere Systems Inc. as it exited the chip-making business. The company also ceased its manufacturing operations, outsourcing virtually everything. In another high-profile retreat, Lucent stopped making gear for wireless phone networks based on technology known as GSM.

The shedding of businesses was sometimes painful financially. And some of the businesses Lucent left had strategic value. The kind of equipment Avaya makes, for instance, has become increasingly important with the rise of Internet calling, and Lucent may well have benefited from keeping such corporate customers as the phone market shrinks. And the market for GSM gear was a lot to leave behind, since GSM is the dominant cellphone technology in Europe and much of the world.

But Lucent has made its cuts with a clear purpose. For instance, instead of staying in the GSM market, Lucent concentrated on a rival technology called CDMA that is prevalent in the U.S. and some developing markets. There, analysts estimate Lucent has about 45% market share. The decision has shrunk Lucent's potential market, but helped its wireless division become the company's chief source of growth and profit, analysts say.

"I don't regret any choices we made where we got out of a business," says Ms. Russo. Lucent's crisis, she says, forced the company to look very critically at what operations were "core and critical" and "what were our nearest and clearest opportunities where customers would spend money."

"They are getting healthier by chopping off limbs," says Lehman Brothers analyst Steven Levy. "It has resulted in a much smaller company that is focused." With so much cost-cutting under its belt, Lucent's profits should grow faster than its revenue in the near future, Mr. Levy says.

Looking to Grow

Lucent also has made less visible, but equally important, efforts to unify internal systems. It has overhauled its order-taking and billing systems, for instance, to make them more efficient.

It also worked to fix its balance sheet. To quell concerns about liquidity, Lucent raised $5.2 billion through the sale of bonds convertible into its common stock. It also raised about $6 billion by selling real estate, manufacturing plants and some businesses. It has pursued tax refunds and recently reached an agreement with U.S. tax authorities to get a refund of $816 million. By June of this year it had cut its total loans to customers to about $216 million.

And through it all there were pink slips. "Morale was very challenged," concedes Ms. Russo, who says management made every effort to convey that it was trying to save as many jobs as possible by cutting enough jobs to keep the company viable.

Now, Lucent is looking to grow again, in part by catching up with some missed opportunities.

Hard times forced Lucent to defer focusing on some promising technologies that weren't quite "nearest and clearest," such as technology associated with sending phone calls over the Internet. But Lucent moved to rectify that as soon as it had a little breathing room. In May, the company announced its first acquisition in about four years, spending $300 million to buy Telica Inc., a maker of Internet transmission technology.

Lucent is now poised to make up lost ground and become a leader in Internet telephony technology, says Merrill Lynch & Co. analyst Tal Liani.

Lucent also is making progress in its drive to be an integrator and consultant capable of mixing its own software and technology with other companies' products to provide comprehensive systems. This small but expanding segment is an important source of growth, Ms. Russo says. In addition, the company is striving to win more government contracts and increase its sales outside the U.S.

Although revenue shrank from $38.3 billion in fiscal 1999 to $8.47 billion in fiscal 2003 before rebounding modestly in the latest year to $9.05 billion, Lucent's gross profit margin soared to 41% in the fourth quarter of fiscal 2004 from 16% in the first quarter of fiscal 2001.

Some analysts have expressed concern because a significant portion of Lucent's recent profits have stemmed from the value of its pension investments. Analysts haven't questioned the integrity of the accounting, which follows conventions, but they are concerned that Lucent's profits will dwindle as accounting formulas dictate a continued decrease in profits from pension investments. The company itself projects that pension investments will make smaller contributions to profits in the coming years.

Mr. D'Amelio, the CFO, says Lucent has been steadily improving despite the decline in the contribution pension accounts make to earnings, as shown by the company's return to profitability. "We're planning to continue to make improvements despite the decline," Mr. D'Amelio says. He adds that the drop in pension earnings actually mutes the earnings effects of the company's operating improvements.

Meanwhile, falling prices represent another painful challenge. "The pricing environment is horrendous," says Mr. Liani. Still, he says "the company in my view will continue to improve, and profits will continue to improve."

Ms. Russo and Mr. D'Amelio say that the lessons Lucent has learned are permanent, and that the company will never again pursue growth without regard to cost or through the types of gimmicks it resorted to before the bubble burst. "We rarely use the word growth without talking about profitable growth and growth with integrity," says Ms. Russo.

Ms. Young is a staff reporter in The Wall Street Journal's New York bureau.

Write to Shawn Young at shawn.young@wsj.com