LUCENT, NORTEL PREDICT PROFITS ARE ON THE HORIZON

Improving margins hold the key to surviving in an uncertain market

Lucent Technologies' first quarter earnings report met Wall Street's diminished expectations, but the company has set up an even higher hurdle for itself by claiming it will reach cash-flow break-even by Sept. 30.

The most visible barometer of telecom vendor health, Lucent reported revenues of $3.5 billion for its quarter ending Dec. 31. That's a steep drop from the $4.8 billion posted the previous quarter but in line with its lowered guidance.

“Because expectations were so low, just the fact that they came in at $3.5 billion was a relief,” said Daniel Shin, research analyst for Robert W. Baird.

Lucent's forecast wasn't as bold as Nortel Networks' prediction of profitability by the end of the year — a stark contrast to its $1.83 billion net loss for the quarter and $27.3 billion net loss for fiscal year 2001.

Both companies' return to the black depends on bettering their margins. Lucent's 13.7% pro forma gross margin for the quarter was 2.2 percentage points better than last quarter, but it's a far cry from the mid-20% margins expected by the end of the year and the 35% margins projected for fiscal 2003.

Frank D'Amelio, executive vice president and chief financial officer for Lucent, said the company believes “margins in the 20s are available to us in Q2.”

Nortel reported a gross margin in its fourth quarter of 30%, up 5% from the third quarter. Despite anticipating a fall in revenue, Nortel claims cost improvements in the next quarter will result in margins in the mid-30s — a range it expects to maintain throughout 2002, according to chief financial officer Terry Hungle.

While various cost-cutting measures will help, most industry observers believe vendors need greater revenues to reach their goals. “They're going to need demand to sustain margins and profitability,” said Gabriel Lowy, vice president of technology research for Credit Lyonnais Securities. “We don't expect that to come back in any meaningful way until next year.”

Neither does Lucent. D'Amelio pegged its break-even quarterly revenue at $4.25 billion, which he says Lucent will reach in the fourth quarter.

“With continued cost cutting and product rationalization, to succeed at its goal of being break-even at revenues of $4.25 billion… does appear reasonable,” Soundview Technology Group wrote in a research note.

But the limited visibility vendors have on capital expenditures from the largest carrier customers means break-even estimates are based on a lot of guesswork.

For example, Verizon — provider of 17% of Lucent's revenue in fiscal 2001 — has not detailed its capital plans and likely will cut spending at least 15% this year, putting even more pressure on Lucent's cash-flow claim, according to Simon Flannery, North American wireline services analyst for Morgan Stanley.

Similar doubts shadow Nortel's claim of profitability by year-end. “I want to just deck the company for saying something like that,” said Shin, whose economic model has Nortel breaking even in the fourth quarter. “They've consistently missed. Their reputation is on the line. Their credibility has been on line and has deteriorated over the last year and a half.”

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With additional reporting by Toby Weber in Chicago.