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Lucent’s Secret Weapon – Accountants

Lucent (LU) attracts some attention in today’s WSJ Article that highlights why it pays to be a big company with a big pension fund in a rising market environment. From the article…

At issue are something called pension credits — the amount by which the pension fund’s income exceeds its current expenses. The year before, such credits accounted for more than half, or $1.1 billion, of the Murray Hill, N.J., company’s reported $2 billion profit. Without
the $973 million pension credit in fiscal 2005, its $1.185 billion profit would drop to $212 million.

I pulled the 10-K this morning, and it is really tough to see this. Lucent didn’t report a $2B profit for 2005, they reported $1.185B. The quote from the WSJ is a little misleading and confused me at first but as always, a deep dive through the footnotes of the 10-K yields the truth. From page F-6 of the recent 10-K…

Approximately two-thirds of these amounts are allocated to operating expenses, with the balance in costs used to determine gross margin. The allocation is based on a recent comparison of salaries that are related to costs and those that are related to operating expenses. Refer to our “Consolidated Results of Operations” section of this MD&A for a further discussion of changes in the net pension credit and the related impact on our results.

Take a look at page F-38 of their 10K. What this means is the operating expenses are reduced by about $600M (2/3) as a result of the pension credit, and cost of goods sold are reduced by about $300M (1/3). The 1/3 in COGS must really apply to the services side of the business, as most labor used to assemble equipment must now be outsourced at contract manufacturers.

Why can’t the contribution from the pension fund be broken out separately in the P&L statement so investors can see what the true operating margins look like? Hats off to the WSJ for reporting this.

It would be interesting to see how Lucent would account for a shortfall in pension funding. It hasn’t happened recently and they have had substantial pension overflows for the last three years. The WSJ article points out that they are not adding many more people to the pension rolls, so it may never happen.

The $34 billion pension plan presently has $2.7 billion more in assets than obligations, and while the assets are likely to grow, the obligations aren’t. That is because the overwhelming majority of people covered by the pension plan already are retired. The pension plan covers 120,000 U.S. retirees, and Lucent has 20,000 active U.S. workers.

Lucent is assuming an 8.5% annualized return on its pension fund assets. If they sustain this number in the long term (tough to do, but possible if markets continue their ascent) they can use balance sheet math to have operating costs comparable to their Chinese competitors. Verizon (VZ) also cleaned up their management pension obligations and may push this out to their broad workforce, putting Verizon in a similar beneficial situation.

Talk about unfair competition!


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