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——— Agere Shifts Gears Thursday August 29, 3:07 pm ET

By Russ Mitchell

This article was originally published on SmartMoney Select on 8/22/02. NOT EVEN A PROMISING pedigree was enough to spare Agere Systems (NYSE:AGR.A – News) the indignities of the telecom meltdown.

Last week, the Lucent Technologies (NYSE:LU – News) spinoff unveiled plans to dump its optoelectronics business, close almost all of its manufacturing plants and lay off 4,000 — a third of its work force. The decision, though drastic, was all but unavoidable in light of the state of the industry and the health of the broader economy. What’s curious, though, has been the stock market’s reaction to it all.

Agere’s shares have been hovering between $1.50 and $1.70, off a 52-week high of $6.30. The price blipped up on the announcement, but only a tad. In other words, the market seems to be saying the news is practically neutral; that huge layoffs, plant shutdowns and a dramatic shift in strategy will leave the company worth about what it was worth before the announcement.

Clearly, that’s absurd. More likely, investors want to believe in Agere, but they don’t trust it yet. And who can blame them? Until early 2001, Agere was the microelectronics group at Lucent. Lucent spun it off because Lucent’s finances were in deep crud, just as AT&T (NYSE:T – News) spun off Lucent in 1996 because AT&T was in trouble.

Agere, for its part, came away with a potentially strong chip business and great technology — its roots go back to Bell Laboratories, and Agere is blessed with 6,000 patented technologies covering optics, integrated circuits and semiconductor manufacturing processes and technology.

But it also came away with horribly bloated operations. In the spring of 2001, Agere had 18,500 employees; by the end of next year that number should be down to 7,200. Lucent, in desperate straits, stuck Agere’s managers and shareholders with $2.5 billion in debt. Lucent also passed on a legacy of strategic mismanagement, which left the company saddled with semiconductor fabrication plants (known as fabs) that companies like Agere can no longer afford.

Credit Agere management for stripping the company down to its essentials. It’s closing all but one of its fabs, turning instead to contract fabrication outfits in Asia, as do most midsize and smaller chip companies. That means not only capital savings, but also savings of $100 million in annual process R&D costs. The optoelectronics business that it’s exiting — chiplike devices that route traffic on long-haul fiber-optic networks — may have brought Agere profits in the future, but it’s a business that may not recover for years. Agere can direct that investment elsewhere.

So where’s the focus going forward? Three chip markets, from fastest to slowest growing:

Wireless networks, including the fast-growing technology known as 802.11 (a.k.a. WiFi), and cellular telephones. Agere is a close No. 2 behind Intersil (NASDAQ:ISIL – News) in WiFi. Among its cell-phone customers is Samsung, which uses Agere chips in its new phones for 2.5G networks. Agere is also a major player in the flourishing cell-phone market in China.

High-density storage. Agere makes three chips essential to storage: One amplifies the signals picked up by the read head in the hard drive; another converts those amplified signals to digital; and a third controls the hard-drive motor. New chips combine the last two functions. Hard drives are commodities, but the chips that control them are not. Agere counts the four largest hard-drive manufacturers as major customers.

Multiservice network solutions. Marketing verbiage for chips that process data in networks. Customers here include Cisco (NASDAQ:CSCO – News), Riverstone (NASDAQ:RSTN – News) and Huawei, also known as the “Chinese Cisco.”

Clearly, Agere’s prospects depend on a capital-spending recovery. The company will lose money this year. But Greg Waters, senior vice president of strategy and business development at Agere, says the company is committed to paring costs to the point where it could break even on current revenues — about $500 million a quarter. “Even if the economy doesn’t improve, even if our business doesn’t improve, our cost structure will allow us to make money,” he says.

Not much money, of course, but Waters says that after breaking even, as much as 70% of new revenues could fall right down to the bottom line. In other words, when the economy turns around, Agere earnings will be positioned to take off, and midyear 2002 would prove to have been a great time to get into the stock.

Of course Agere, which is ranked as the No. 1 vendor of communications chips by Gartner, must execute — particularly with companies like Intel (NASDAQ:INTC – News) paying more attention to those very same communications chips. And Agere’s Lucent legacy gives cause for pause. But Waters, who came from Texas Instruments (NYSE:TXN – News) three years ago, says two-thirds of top management joined the company within the past two years. Another good sign.

Adding his two billion cents to the stock-options debate this week, Bill Gates said expensing options would have little negative effect on innovation.

In a recent column I argued that forcing young start-up companies to expense options would weigh down their net income, extend their periods of losses, make it harder for them to raise capital and, in the end, stifle innovation. I’m hardly the only one making that argument.

If Gates means that expensing options won’t slow innovation at huge, established companies such as Microsoft (NASDAQ:MSFT – News), he’s probably right. But if smaller, more innovative companies find it tougher to raise money, then it lowers the odds that new breakthrough technologies will emerge to challenge the giants…like Microsoft.

Russ Mitchell is a veteran technology journalist based in San Francisco.


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