Beleaguered Giants

This month, I take a look at three large companies whose stocks have been downsized dramatically, and whose futures are so dark, you’ll have to wear a headlamp. True, all of them hold a dominant position within their industries. They’ve got the right stuff, but their industry sectors as a whole may be doomed to slow or even no growth for the near term. While I don’t think this bleak forecast will stop two of the three companies in their tracks, there’s one that could get derailed.

Basking Ridge, New Jersey-based Avaya (www.av.com) is a communication systems and software firm with an emphasis on converged voice/data networks (wired and wireless) and customer service systems. If you haven’t heard of Avaya–or at least don’t know whether you’ve heard of it, thanks to its generic-sounding name–Avaya has 23,000 employees and is a world leader in the call center, voice messaging, and interactive voice response markets, and number three globally in IP (Internet protocol) telephony.

Avaya was the Enterprise Networks Group of the beleaguered Lucent Technologies, and was spun off from Lucent on October 2, 2000. Everyone who held Lucent got shares in Avaya, so Avaya is one of the most widely held stocks in America, with about 3.7 million shareowners. Make that 3.7 million unhappy shareholders.

Avaya has naturally spent its first year engaged in various restructurings, including consolidating real estate, updating technology, cutting the workforce by 30% in the 18 months through September 2001, expanding overseas (particularly in the Pacific region), increasing R&D spending, completing acquisitions, and outsourcing communications systems manufacturing, procurement, and payroll.

Currently more than three-quarters of Fortune 500 companies use one or more of Avaya’s services, and Avaya was itself added to the Fortune 500 index on November 7, 2001. (Fortune considers adding spin-offs after they’ve had a year on their own.) That’s a nice calling card.

Integration is the key to Avaya’s products and services. In essence, all of Avaya’s hardware, software, and services are oriented toward the creation of seamless networks of voice and data, allowing for more efficient business operation and better customer relationship management. For example, when you call your broker or any large firm, you should be able to expect that the person who answers the phone will know who you are (at least if you call from home), have your account records instantly ready on a computer screen, and be ready to make transactions (perhaps after asking you for a code number).

Similarly, within a company, voice messages, text, and often video should be readily available to recipients whether they’re in their offices or on the road. And for many firms, these interactions with customers, suppliers, employees, and consultants should be cross-linked as well as protected, so everyone knows what he or she has to know as quickly as possible without unauthorized people learning private or proprietary information. All of the mind-numbing details of hardware, software, and services–which I’m not going to get into here–are really just designed to do these three things. When well implemented, they mean faster and more reliable service, and ultimately, happy customers. And if employees are spending less time looking things up on a multitude of different systems or waiting for marching orders, such an integrated system may also reduce labor as well as hardware costs. Naturally, these systems can also be extended into academic, medical, nonprofit, and government offices.

To keep up with the competition, Avaya spends about 8% of revenue on research and development, with over 3,000 scientists and engineers working at Avaya Labs. In terms of hardware, companies on the technology frontier are always working on expanding bandwidth, flexibility, and reliability, with portability frequently a factor. As for software, Avaya is working on better intelligent systems for speech recognition (you can now get your e-mail and calendar listings from a telephone), predictive algorithms to improve service efficiency, and improved graphical visualizations to help people to interpret data.

Like the rest of the industry–indeed, almost all industries–Avaya has been hurt by 2001′s economic slowdown, and particularly by the aftermath of September 11. The company’s revenues from ongoing operations for fiscal 2001, which ended September 30, 2001, came to $6.8 billion, down 9% from $7.5 billion for fiscal 2000, with revenue for the September quarter coming to $1.4 billion, down from $2 billion a year earlier. “With the economic difficulties that are already apparent for 2002, we are taking a conservative view and are preparing for a decline in revenue on an annual basis, and approximately flat sequential revenue in the first quarter 2002,” says CFO Garry McGuire.

The stock was recently selling near $9 per share, much closer to its 52-week low of $8.57 than its high of $19.24. With 282 million shares outstanding, and a recent price of $9.18, Avaya’s market cap is $2.6 billion. That’s less than half of its past year’s revenues of $6.8 billion.

Although not everyone will agree, it’s clear to me that the ratio of market cap to operational revenues is the most meaningful valuation measure for this and other tech sectors. Price-to-book value means little when a firm’s value is so tied up in its employee and customer relationships, and even the values of its tangible assets change so rapidly (with electronic gear always rapidly depreciating and becoming obsolete).

And figuring a meaningful price/earnings ratio is often far more problematic. At $9.18, Avaya is selling for seven times 2001 estimates of $1.25 in earnings from “ongoing” operations, excluding restructuring charges. (Restructuring plans this year have included eliminating about 11% of its workforce, or 3,000 jobs.) But in an industry where technologies change every year, and restructurings are continuous, the notion of operational profit becomes nearly meaningless; during an economic downturn, as we’re seeing now, many firms will have no profits for a while, and almost all firms will have diminished profits compared to reasonable expectations following the recovery.

Of course, in some industries, even revenues, and thus the price/revenue ratio, can become meaningless. The most egregious recent example has been the dot-coms that traded banner ads on each others’ Web sites; no cash changed hands, and it was arguable whether the ads were actually worth much. But those barter deals were valued at whatever the companies thought they could get away with, distorting revenue figures sometimes by orders of magnitude. (For some firms, these barter advertising deals made up the lion’s share of “revenues.”) In more traditional businesses, revenues are typically inflated by shipping goods on very generous billing or financing terms to wholesalers or customers who may never be able to pay for them. When this recessionary trend reverses course, Avaya’s stock should speak volumes.

Telecommunications

Too Much of a Good Thing

Global Crossing overbuilt its data networks, but patient investors may yet see rewards

Global Crossing (GX), with the slogan “One Planet, One Network,” specializes in hardware and services to provide a high-bandwidth global fiber-optic network backbone covering 27 countries with 100,000 fiber-optic route miles–the world’s most extensive optical Internet Protocol (IP) network.

Bermuda-based Global Crossing (www.globalcrossing.com) was launched in 1997 and had its IPO on August 13, 1998. Since then it’s spun off Asia Global Crossing as a partnership with Microsoft and Softbank (although Global Crossing is still the majority holder), and bought the undersea cable maintenance and installation unit of Cable & Wireless in July of 1999 for $850 million.

While the business model looks fine on paper, there’s been a disconnect with profitability. In addition to the more generalized economic slowdown, followed by the shock of September 11, the downturn has had a disproportionate effect on the telecom sector.

And Global Crossing has had company-specific bad news as well. The firm announced on October 4 that it would not meet its third-quarter earnings predictions, and fourth-quarter revenue would likely be 25% below expectations. The company also announced the arrival of its new CEO–its fifth CEO in three years–and put forth the news that the Global Crossing would be dropped from the S&P 500 index. The stock price was cut in half, from $2.09 to $1.07, and the next day the firm’s 9.5% bonds (due 2009) were traded down to 15 cents on the dollar. Instead of crossing the water, Global Crossing suddenly looked like it was going to submerge.

I’m not a big fan of the argument that with stocks under a dollar, “the most you can lose is a dollar.” It’s literally true, of course, but losing 100% is just as painful with 10,000 shares at $1.00 as it is with 100 shares at $100. Still, if the market has brought a stock down to $0.88, as it has with Global Crossing, that does compensate for a lot of bad news and risk. With all the bad news out, there’s often a considerable upside if and when things turn around.

Despite the tough current market, the company’s plan–to provide virtually unlimited data capacity globally–is a sound one. The question is whether they have overbuilt and overborrowed for this particular time in the business cycle. Globally, fiber-optic cables are being used at under 3% of potential capacity, and increased demand will rely on huge increases in end-user connections. Until those connections are built up, growth will depend in large part on grabbing market share from the competition, a battle of pricing as much as service quality.