Lucent Should Stick With What It Knows

For a company whose roots are in Bell Labs, source of innumerable technological breakthroughs, Lucent is surprisingly unembarrassed about buying technology that it can’t, or doesn’t want, to build itself. Since it was spun off from AT&T three years ago, Lucent has made 29 acquisitions at a cost of $32 billion, including a major deal it closed today, when it agreed to acquire Excel Switching Corp. for $1.7 billion.

While it’s now well known that at least half of all mergers fail–in the sense that they destroy rather than create shareholder value–it’s also become well known that certain companies are exceptionally good at integrating acquisitions into their existing operations. Not coincidentally, perhaps, two of the best are competitors, namely Lucent and Cisco (which, reader beware, I own shares in). Cisco, in fact, closed a small deal today, spending $143 million to acquire MaxComm Technologies, which specializes in high-speed Net access. And before the year is out, expect Lucent and Cisco to announce more deals. It’s a kind of acquisition arms race.

For the most part, the logic behind that race is compelling. Lucent, with its roots in more traditional telephone equipment, is trying to move strongly into computer and data networks. Cisco, for its part, wants to build on its already commanding position in data networking, even as it shifts more and more of its business to take advantage of the explosion in the Internet. And with technology shifting and developing as rapidly as it is, it’s difficult (let’s say impossible) for any company to keep everything in-house. Instead, smaller companies create and develop technology, and Cisco and Lucent step in, buy up these companies with their pricey stock, and reap the benefits. Needless to say, this strategy works only if you’re good at bringing companies on board without wrecking them or yourself. Both Lucent and Cisco are.

The danger in all this, though, is overreaching, stretching a company beyond what it’s really good at. Take last week’s $3.7 billion acquisition by Lucent of International Network Services, a telecom consulting firm that helps companies design, install, and maintain computer and data networks. The deal was hailed by analysts and the press as a powerful move by Lucent into “services,” offering the possibility that companies will now be able to come to Lucent for one-stop shopping. Not only will we sell you the equipment, Lucent can now promise, but we’ll help you install it and keep it running. Hell, we’ll even tell you why you should buy it in the first place.

That last point signals one of the obvious problems with the deal, which is that INS’s business depends on the fact that companies trust it to give them the best advice possible. If, every time a company asks an INS consultant what kind of system it should install, the consultant says, “Why, Lucent, of course,” companies aren’t going to be trusting INS much longer.

But even aside from that, this was a dubious acquisition, because in essence Lucent paid $3.7 billion to buy a business whose profit margins and earnings growth are significantly lower than Lucent’s. This may seem counterintuitive, given that all you hear about lately is how important it is that IBM is moving into services–i.e., its e-business initiative–or that Hewlett-Packard is revitalizing itself as a services company. But the truth is that it’s better to make hardware or software than to be in services. Consulting is a fine business, on its own terms. But next to making switches or routers–let alone Windows 98–it’s mediocre at best.

The reason is obvious: Services require people, and always will. When you’re making hardware or, even better, licensing software, all your costs are under your control, and once the product is actually developed, your profit margins are very high. And production lines can be automated. Consulting, though, is by definition a labor-intensive, time-intensive business. Profit margins are much lower. INS’s net margins–profit divided by revenue–are around 8 percent, while Cisco’s are at 20 percent. This is inherent in the nature of the business–Lucent won’t be able to change it.

It’s understandable, what with the new vogue for one-stop shopping, that Lucent would want to offer services in addition to equipment. But in acquiring INS, Lucent appears to be forgetting one of the most important lessons of the past two decades: Companies do best when they do only what they do best.