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Alcatel: So long Lucent, hello profit warning

Alcatel waited to announce its profit warning until the merger deal was officially off the table. Interesting timing--some analysts say the company was playing the Wall Street game.

On Wall Street, timing is everything. Just ask Alcatel, which used the demise of its merger talks with Lucent Technologies to drop a profit warning.

After weeks of speculation about an Alcatel and Lucent combination, the two telecommunications equipment companies ended their talks Tuesday. Lucent was rankled because Alcatel viewed the Murray Hill, N.J., company as takeover bait. Lucent wanted a merger of equals, with its executives enjoying a lot of clout with the combined company.

Once the deal was officially off the table, Alcatel executives said its telecommunications equipment unit would lose $2.57 billion in the second quarter after restructuring charges and write-downs for inventory and 360networks convertible bonds. Alcatel's optical components division also cut its 2001 forecasts.

Analysts said Paris-based Alcatel was simply playing the Wall Street game. By leaking the talks with Lucent to the press and watching shares stumble, Alcatel knew that investors would be relieved once the merger fell apart. That relief would theoretically cushion the blow from the profit warning.

"Alcatel took advantage of the relief that investors might feel from its decision to break off talks with Lucent to once again adjust its earnings projections," said Francois Travaille, an analyst with BNP Paribas Equities, in a research note. Travaille rates Alcatel a "neutral."

"The timing was perfect," said Syed Haider, an analyst at Frost Securities. "Alcatel didn't waste time setting its course as a standalone firm."

Nevertheless, shares of Alcatel's American Depository Receipts fell more than $2.42, or 8 percent, to $24.99 Wednesday, but analysts said it could have been worse. They said it's likely that Alcatel had already determined a few ways to deliver its profit warning, depending on how the talks with Lucent went.

If Lucent had decided to be acquired by Alcatel, the conqueror may have repositioned its profit warning. Alcatel, which may have couched the write-downs amid a Lucent integration effort, could have taken a "big bath" charge once the two combined their operations--it's not like Lucent and Alcatel don't have big cost-cutting goals. Big bath charges are write-downs used to wipe balance sheets clean. The most obvious example is Cisco Systems' recent $2.25 billion inventory charge.

"It's just conjecture, but I'm sure Alcatel wouldn't have announced the profit warning if the merger had gone through," said Craig Johnson, an analyst with the PITA Group.

It's standard practice for two merging companies to take big restructuring charges that inevitably wipe the slate clean and hide slowing growth. Acquisitions and pro forma earnings can hide a lot of flaws.

"I think Alcatel already had this restructuring effort in mind," Haider said. "If the Lucent deal went through, there would have been one big charge. You have to clean up your balance sheet in a market like this."

When Lucent pushed back on Alcatel's terms, the would-be acquirer knew it had some issues. Investors had already knocked shares of Alcatel down about 14 percent since word of the Lucent talks circulated.

Analysts said Alcatel's negotiating tactic was to take advantage of Lucent's weak position. Lucent, which has lots of debt and losses, may have been able to make a better case for a merger of equals if it were clear that Alcatel's operations were struggling. "To pass this off as a pure acquisition, Alcatel would have had to offer a higher premium," Travaille said. "We also believe that Alcatel realized that its earnings profile was not favorable."

Travaille noted that value of the Alcatel-Lucent merger would have fallen if Alcatel had to come clean about its earnings. If the value of an Alcatel-Lucent combination fell, investors would have really been irate.

So what's next?

Haider said Alcatel remains in solid financial shape and the restructuring move is par for the telecom equipment course these days. Haider said Alcatel is hardly alone--Lucent, Nortel Networks and Cisco have all announced restructuring plans. Nevertheless, Morgan Stanley analyst Angela Dean noted that Alcatel's restructuring plans were vague at best.

Lucent, which has lost $3.68 billion in the fiscal second quarter, has to get back to basics, cut costs and show some innovation. Lawrence M. Harris, an analyst with Josephthal, said Lucent has to pick up the cost-cutting pace.

Through the end of April, Lucent cut its work force by 2,000 employees, or about 2 percent, against a target of 10,000 to 16,000 employees, Harris said. Meanwhile, Nortel is halfway to its target of 20,000 job cuts.

Analysts also read between the lines about Lucent's future. Because Lucent was set to take no premium to merge with Alcatel, analysts surmised that management can't be too confident about a return to the glory days.

"The fact that Lucent is apparently willing to entertain such extensive negotiations absent a significant valuation premium suggests to us that Lucent's management does not have strong conviction in its ability to significantly, profitably grow its business in the current environment," said Paul Silverstein, an analyst with Robertson Stephens.