Lessons from the Lucent Debacle Think twice about what you promise Wall Street. And don't send a lumbering old company to do a startup's job.
By Stephanie N. Mehta Reporter Associate Irene Gashurov

(FORTUNE Magazine) – Henry Schacht, Lucent Technologies' once-and-again CEO, has a simple story to tell, and he's sticking to it. He told it to the press in October to sum up Lucent's year of woes when he took over the company for the second time in five years. He told it to Wall Street in December when he announced that Lucent would have to go back and cut revenues by $679 million for the fiscal year that had ended three months before. And he told it to FORTUNE in January when he made the case for why Lucent would remain a top-tier supplier in the increasingly complex telecommunications industry. On that occasion, at the end of a long discourse that was part business-school case study, part mea culpa, Schacht concluded: "The single lesson you get out of Lucent is, Don't try to run the business faster than it's able to run."

Lucent shareholders might wish he had made that declaration a year ago. Today, Schacht does not have an enviable job. To restore Lucent's luster, he will have to cut costs, reorganize management, and resist Wall Street's demand for headlong growth. He'll also have to appease frustrated customers, rebuild morale among employees, and regain the confidence of investors who have lost $200 billion in market value in the past year. Schacht's predecessor, Richard McGinn, who was fired by the board, has to answer for much of what happened. (Reached for comment, McGinn maintains that Lucent's recent troubles stem largely from "a missed product cycle in optical systems.") But Schacht bears responsibility as well. He was Lucent's first CEO, and he handed the company to McGinn. He has also been on Lucent's board since its inception. Now, at the request of the board, he has come out of retirement at age 66 to take this job. At his second inaugural address to employees, he played a clip from The Godfather Part III--the bit where Al Pacino says, "Just when I thought I was out, they pull me back in."

A Pennsylvania native, Schacht speaks with a quiet confidence that comes from 40 years in business, 31 of them with Cummins Engine. Cummins had gone through tough times, and he turned the company around. But the turnaround he will have to engineer at the $34-billion-a-year Lucent may be the biggest challenge of his career. Dozens of interviews with customers, competitors, and current and former employees of Lucent tell a cautionary tale for the post-bull market era. It is an account of management that became so focused on near-term growth that it offered deep discounts and wildly generous financing arrangements for its customers. The hunger for growth also clouded Lucent's ability to forecast where its business was going.

How did Lucent adopt this go-go mode in the first place? After all, Lucent was carved out of AT&T, a former monopoly, and it traces its roots to stodgy old Western Electric--hardly the DNA of a company that chases growth obsessively.

It may be helpful to begin at the beginning. When AT&T spun off Lucent in 1996, investors and analysts expected the slow-growing equipment arm to get a nice little kick in its bottom line from expense reductions and a tidy boost in sales simply from being independent. AT&T rivals such as MCI and the Baby Bells felt more comfortable buying from Lucent once it was a stand-alone company.

But the boost Lucent got was more than small. Around the time the company went public, the telecommunications industry was on the verge of unprecedented expansion. In 1996 Congress passed legislation to make it easier for carriers to compete with the local phone monopolies. The robust economy and the introduction of Internet services fueled consumer demand for second and third phone lines, prompting the Bells to buy billions of dollars of equipment to expand their networks. Wireless, too, began to take off in the U.S. Lucent successfully positioned itself as an arms merchant to the battling phone companies, selling to incumbents and emerging competitors alike. In fiscal 1997 Lucent sales rose 13%; the following year revenue climbed 20%--and earnings a staggering 49%. At that rate, Lucent outpaced the overall growth of the telecom-gear sector, grabbing market share from other big manufacturers such as Motorola and Canada's Nortel.

Lucent executives didn't think this kind of growth was an aberration. Their mantra for investors and the business press was that Lucent's revenue would grow three to five percentage points faster than the overall telecom-equipment market, which was growing at 14% to 17% annually. In other words, Lucent would grow by 17% to 22% a year.

Wall Street loved hearing this. Even by bull-market standards, Lucent was a standout. By the end of 1998, the value of Lucent shares had risen eightfold from the IPO price, strongly outperforming the S&P 500 and far outshining its former parent. This was a source of great pride at Lucent; according to former employees, many of the folks at Bell Labs, now part of Lucent, had felt overshadowed at AT&T and reveled in showing Ma Bell that Lucent could succeed on its own.

Those were proud days, too, for Richard McGinn, who succeeded Schacht as CEO in 1997. A Bell System lifer, he had run AT&T's network systems unit and had hoped to lead Lucent at the time of its spinoff. According to people familiar with the matter, he was furious that AT&T's board had tapped Schacht to run Lucent first and "groom" McGinn for the CEO post, although McGinn was unfailingly gracious about his role in public. Some in the industry suggest that McGinn may have felt he had something to prove to those who initially passed him over.

Pretty soon Wall Street types started mentioning Lucent--Lucent!--in the same breath as highflying tech companies such as Cisco, Intel, and Microsoft. And because Lucent was so widely held, its stock performance was a way for the average Joes, widows, and orphans to participate in the bull market. That made Lucent executives a little giddy: The company specifically set out to increase its base of individual shareholders, sending representatives to attend individual investor conferences and to speak to investor clubs. McGinn, grinning with delight, once told a visitor about going into a pizza place, where he saw one of the workers stare at the stock ticker running across the television screen and call back to the kitchen, "Lucent's up!"

But Wall Street is a fickle suitor, and its love affair with Lucent was conditioned on top-line growth. The day Lucent announced a revenue increase of 6% for its first quarter of 1999, investors pushed shares down 7%--never mind that it had also reported a 26% jump in earnings.

Meanwhile, a new breed of competitors had their eyes fixed on Lucent's bread-and-butter customers--the phone companies. The super-efficient Cisco Systems entered Lucent's territory with gusto, pitting its data-centric view of the world against Lucent, which supplied old-world telco networks as well as new-world data networks. Also, a raft of fast-moving upstarts that specialized in optical networking began shipping products to Internet carriers and other communications companies. They had no market share to protect, only share to steal from the likes of Lucent.

So began a fierce fight to win customers and protect revenue growth. Telcos that were once considered "Lucent shops" because they favored the company's gear were now up for grabs. And that seems to have been when Lucent started to cut some fairly brash deals to hit its revenue targets--deals that have hurt the company and could do further damage.

Most notably, Lucent has participated heavily in so-called vendor-financing arrangements, particularly to win business from new carriers with no earnings and limited funds to pay for equipment. Lucent would lend customers the money to buy the gear (and sometimes to pay for engineering and installation too); terms were generous, and payment was often deferred. At the end of fiscal 2000, Lucent had extended $6.7 billion in credit to customers; about $1.3 billion of that sum had actually gone out the door.

Lucent wasn't alone in cutting such deals. Rivals Cisco and Nortel also financed equipment purchases, and offering loan packages became part of the process of bidding for customers. But you have to wonder why Lucent pursued some of its customers in the first place. By early 2000 several new carriers were showing signs of trouble, laying off workers and shuffling management. Yet Lucent continued to make new loans and to expand existing credit facilities to companies in this sector.

Last year, for example, Lucent arranged to lend $35 million to a subsidiary of KMC Telecom, a closely held phone company to which it had previously agreed to lend up to $450 million. KMC doesn't owe Lucent any principal on most of that sum until 2003, and some telecom analysts are betting the carrier won't be around by then. The company lost $185 million during the first six months of 2000, and its bonds today trade at less than 30 cents on the dollar. With customers like that, who needs enemies?

So far the fallout from Lucent's pursuit of upstarts has been minimal; in fiscal 2000 the company wrote off $69 million in uncollectibles, down from $112 million the year before. But additional write-offs could loom as more Lucent customers struggle.

In making these deals, Lucent may have had other motives besides building its business. "It does raise the issue of whether companies like Lucent were buying their sales and playing to Wall Street," says Cecilia Ricci, a finance professor at Montclair State University who has written a paper on vendor financing in telecom. "All they were concentrating on was revenue growth."

Schacht acknowledges that some of Lucent's vendor-financing customers may run into trouble and says the company has adopted a more conservative lending policy. "We did not make loans in anticipation of writing them off," he says. In some cases, he adds, "we didn't get it right." But he notes that Lucent will continue to use vendor financing to win business.

Lucent also indulged in another risky practice: offering some of its biggest customers deep discounts to make purchases they might otherwise have postponed until a later quarter. These discounts are a common sales incentive, especially at the end of the calendar year, yet they can have bad consequences. The seller gets an immediate pop to the top line, but at the expense of a future sale at list price. Some Lucent customers say they received substantial discounts to make purchases in the quarter ending Dec. 31, 1999--the quarter in which both Lucent's earnings and its revenues first fell short of expectations. In sewing up many of its customers' equipment needs on the cheap, Lucent was bound to have a hard time making its numbers later in the fiscal year.

Lucent's discounts are a gift that keeps on giving too. In a lawsuit filed in New Jersey Superior Court, a former Lucent group president alleges that the company "mortgaged the future" by promising additional discounts to carriers who buy products in 2001. The plaintiff, Nina Aversano, ran North American sales until Lucent announced her retirement in October. She claims McGinn ordered her to retire after she presented material showing that 2001 sales in her region would fall short of growth targets, in part because of those promised future discounts.

Lucent declines to comment on the lawsuit, but Schacht says Lucent's use of discounts is legal and properly accounted for. Still, the issue of credits was the source of some of Lucent's fourth-quarter "revenue recognition" woes. Specifically, Lucent reduced revenue by $125 million because a sales team improperly extended credit to a customer. The company pared back revenue by a further $74 million to reflect credits that apparently were offered orally to customers. (Lucent also decided to take back $452 million for equipment that distributors had failed to resell or install and another $28 million for a system that had been incompletely shipped.)

Throughout 2000 Wall Street steadily lost patience with McGinn because he refused to temper growth projections, even in the face of mounting shortfalls. Just days before warnings of a fourth-quarter shortfall, for instance, McGinn told FORTUNE that strong demand for wireless and Internet gear would buoy sales.

Some of McGinn's defenders suggest that his optimism was based on rosy projections from his executive team. And, in fact, plenty of other Lucent executives talked up the company's outlook. In an interview with FORTUNE in July, chief strategist Bill O'Shea declared: "What's rewarded is growth and the prospect for growth. We have a strong foundation for great growth opportunities for the future." Some customers and others close to the company say Lucent superstar Carly Fiorina, who left in July 1999 to become CEO of Hewlett-Packard, was an early advocate of the growth agenda. She intimated to employees and outsiders that Wall Street would generously reward companies that emphasized and delivered robust revenue growth. Aversano, who in her lawsuit claims she also warned McGinn that growth projections were too high, doesn't emerge unscathed either. People close to the company say she authored some of Lucent's most aggressive deals and pushed hard for loans to a number of upstart phone companies, including KMC. Aversano, through her lawyer, and Fiorina declined to comment.

Lucent's growth strategy also hurt operations. By consistently "pulling forward" sales that customers might otherwise have deferred, the company diminished its ability to forecast demand. Schacht says one product-development unit last year simply had to guess what customers would buy in 2001. Sure enough, the unit guessed wrong, but by the time this became clear Lucent had manufactured products that were out of favor. Schacht says such problems plague the entire company, which helps explain why inventories grew 34% in fiscal 2000, far outpacing annual revenue growth of about 12%.

Lust for growth also prompted McGinn to restructure the company into 11 different business units, which he used to refer to as "11 hot little businesses." The idea was that these units, operating separately, would be less bureaucratic, more market-focused, and faster-moving. But this structure may also help explain one of the biggest mistakes in Lucent's history: its failure to develop optical-networking gear for superfast OC-192 systems to carry long-distance voice and data traffic. According to Schacht, Lucent's scientists believed customers would want to deploy these fast networks, and they urged Lucent to develop lasers and switches for them. But the optical unit--one of the hot little businesses--instead sought to boost network speed by increasing the number of light streams pumped through standard optical fiber. Nortel bet on OC-192, and rode it to dominance of the optical market. Lucent missed out on hundreds of millions of dollars in potential sales.

Then, in its haste to play catch-up with Nortel, Lucent misstepped again. Industry sources say that in fall 1999, Lucent asked Qwest to buy some of its OC-192 gear. Qwest, which was Nortel's first OC-192 customer, grudgingly agreed to install the products. It was a disaster. Lucent rushed to get the system into Qwest's network before the gear was ready for deployment. Qwest refused to comment on the matter, but sources say Lucent ended up crediting Qwest's account for its troubles. McGinn, who declined to comment on other parts of this article, said the miss in optical systems was the cause of Lucent's financial underperformance in 2000: "As carrier investment recovers in the latter part of 2001, I believe Lucent will reassert itself because of its focused research and development and the quality of its people."

Where, in this interconnected web of pain, were Schacht and the rest of the board? As long as a year ago inventories and receivables were far outstripping revenues--a sure sign the company was making things that nobody was paying for. Didn't the board notice?

Schacht seems willing to accept responsibility but not blame. "We are accountable. Anytime you decide that you have to make the kind of fundamental change that we've made, you always wonder why you hadn't done it sooner," he says. Asked why he believes Lucent was consumed with growth, Schacht says only that the pressure was "self-induced." He lays some of the blame on the irrational stock market of the late '90s, which rewarded top-line growth. But, he says, Lucent should not have fallen for that. "Stock price is a byproduct; stock price isn't a driver. And every time I've seen any of us lose sight of that, it has always been a painful experience," he says.

Now Lucent is in the middle of a different recovery plan; only, this time the company isn't rushing things. Schacht has declared 2001 a rebuilding year, and investors should expect the next few earnings periods to be rocky. He is on the verge of announcing a major restructuring that includes layoffs and significantly more than $1 billion in cost savings. Schacht hopes the company will start fresh in 2002 and end the year with revenue growth at--or slightly above--the growth rate of the industry.

In the meantime he's looking for a successor (again). The ideal candidate is someone who understands technology and knows how to turn companies around. But these days turnaround experts are in demand. Schacht may have to wait a while before he can at last retire for good.


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