Outside Audit
Does Merger of Equals Designation Ring True?

When they acknowledged they were in deal talks last week, Lucent Technologies Inc. and France's Alcatel SA described their potential combination as "a merger of equals."

Yet that's not the case in at least two important ways. The first, obvious way: The stock-market value of Lucent is less than $14 billion, versus over $21 billion for Alcatel.

The other: The stock market appears to place a much higher value on the income that Lucent derives from making telecommunications equipment than it does on Alcatel's income from its telecom-equipment operations.

The logic behind that assertion has to do with the fact that Lucent, Murray Hill, N.J., last year "earned" a huge chunk of its income from its pension plan. Accounting rules allow a company to incorporate income from its pension plan into its operating earnings. But skeptical analysts often factor out the pension earnings, figuring that how well a company's retiree benefits are doing says nothing about its ability to run its everyday business.

Caroline Mille, an Alcatel spokeswoman, said, "Of course we are aware" that Lucent derives much of its income from its pension plan. She declined to comment further. Mary Lou Ambrus, a Lucent spokeswoman, declined to comment.

Lucent shares trade at about 13 times the company's 2005 operating income, while Alcatel shares trade at about 15 times operating income. Both multiples are roughly in the range of other telecom-equipment companies: Motorola Inc. trades at about 12 times operating income, while Nokia Corp.'s multiple is about 17.

But without the income it earns from its pension plan, Lucent's share price as a multiple of its operating profit soars.

Last year, Lucent reported $647 million in credits from its pension and retiree-benefit plans combined. The pension and retiree earnings made up about 61% of Lucent's $1.06 billion in operating income for calendar 2005.

Strip out that money, and the income Lucent generated from making telecom equipment falls to $413 million for 2005. And its multiple rockets from 13 times operating income to 33 times.

In 2004, the last year for which complete figures are available, Alcatel recorded a loss of €54 million (about $65 million) from its pension plan as part of its operating income. If that were applied to 2005 earnings, stripping it out would cause its multiple to drop a fraction of a point, though it is still 15 times operating earnings.

So, Alcatel, the larger company by market value, is coming together with a company whose operating income is more richly valued. Bottom line: Alcatel looks more like an acquirer than a merger partner.

"When we've done our valuation [of Lucent], we'll do our valuation excluding the pension and tax implications," says Simon Leopold, a Morgan Keegan & Co. analyst. "It's not quite the attractive valuation that people might at first think it is."

Still, he says, the companies may have other reasons for insisting on calling the deal a merger of equals: where the combined firm's headquarters will be, which executives will stay, how many board seats each side will get. Indeed, in 2001, Lucent walked away from talks with Alcatel about a merger of equals because the U.S. company feared it was looking more like an Alcatel takeover of Lucent.

Write to Michael Rapoport at Michael.Rapoport@dowjones.com