Demanding customers make good innovators.

Speed and relentless customer demands force CEOs to operate beyond their 'comfort zone' when it comes to pushing for new products and services. Surprisingly, a 29-year career AT&T veteran is very comfortable with that.

Joseph Schumpeter's creative destruction captures the classic theory of innovation. The Austrian economist believed that innovation comes from outside an industry's current leaders because they have too much at stake in exploiting what made them successful in the first place. That success can pose a formidable dilemma is a fact not lost on Rich McGinn, 51, Lucent's chairman and CEO. Since its spin-off from AT&T in 1996, Lucent's stock, like the Energizer bunny, just keeps going and going and going. In May, it was trading at about $74 a share, or 60 percent above its 200-day moving average.

The company kicked off its fiscal 1998 with first quarter revenue growth of 16 percent and earnings growth of 28 percent. Fueling this growth are strong demand from both the former RBOCs and emerging wireline and wireless providers that are spending aggressively. This trajectory is likely to continue through 1999, says J.P. Morgan's Gregory Gelling, who estimates that Lucent will achieve 18 percent compound annual core revenue growth and 28 percent earnings growth through the end of next year. With a market capitalization of around $95.5 billion, the spin-off is now worth more than its former parent AT&T, which has a market cap of $93.9 billion.

Before his elevation to CEO last year, succeeding Henry Schacht, former chairman of Cummins Engine, McGinn moved aggressively as Lucent's operating chief to keep the development engines humming. Annualized revenues are running at more than $30 billion, with 11 percent earmarked for R&D as the company tries to push more deeply into intelligent networks, data networking, and Internet access. Supporting this effort is Bell Laboratories, the world renowned former R&D unit of AT&T that invented the transistor, the communications satellite, the laser, Touch-Tone dialing, electronic switching, and cellular telephony - just for openers. Today it's focused on high potential technologies such as digital signal processing, photonics, and high-speed networking. "The focus is less on invention than on getting inventions to the marketplace," says Bell Labs President Dan Stanzione, who adds that four years ago, about 25 percent of the company's rapid growth products were less than three years old. Today it's more than 60 percent.

Lucent faces two sets of tough competitors-traditional telecom equipment makers such as Nortel, Ericsson, Siemens, and Alcatel, and highly innovative network providers such as Cisco, Bay Networks, and 3Com. "Lucent's behavior needs to be much more like that of those 'little companies' - innovative, fast, and flexible," says Deutsche Morgan Grenfell analyst Jim Parmelee. "What I call the Silicon Valley model." With the telecoms industry in hyperdrive, a dramatic shift in investment towards high capacity data networks and Internet access is under way. As Internet traffic grows 1,000 percent a year and data traffic over the public network doubles annually, public carriers are scrambling for cost-effective ways of handling voice, data, and video transmission.

Knowing that few firms are able to do all things equally well, McGinn is not reluctant to go outside the company for technology solutions. This has led to a number of alliances, partnerships, and acquisitions, including messaging telephony company Octel, Ethernet switchmaker Prominet, and data equipment supplier Yurie Systems. "Lucent's getting more from the outside than at any previous time," says Arno Penzias, former Bell Labs research VP, "but we're also getting better at aligning our total R&D portfolio with our strategy."

McGinn built his career on an AT&T foundation, graduating from Grinnel College in 1969 and taking a post as account executive at Illinois Bell, the traditional proving ground for AT&T executives. He joined AT&T in 1978 and held executive positions with its international and computer systems groups. Having headed AT&T's equipment operation before the split, he was thought to be the lead candidate for Lucent's top job, but Robert Allen, then AT&T's chairman, tapped Schacht, who had more operating experience, instead. Nonetheless, the two top leaders worked closely in forging a new enterprise. "The speed with which McGinn has created a new culture without losing the best of the old AT&T is impressive," says Mary- Henry, managing director and telecoms analyst with Goldman Sachs. "Clearly McGinn and his team are running on all cylinders," adds Morgan's Gelling. Both analysts say the company needs to develop a stronger presence in wide area data networks and to push for more market share outside the U.S.

In the following interview at Lucent's Murray Hill, NJ, headquarters, McGinn argues that the "I want it now" demands of customers coupled with the speed of technology, force companies to cannibalize their own offerings before someone else does. "Let's face it, most leaders are comfortable defending what they know, but a good CEO can make a difference if he's willing to operate outside his comfort zone," contends Penzias. "There are darn few who can do this well - H-P's Lew Platt is one' McGinn is another."

- J.P. Donlon

A DOLLARS TO DEVELOPMENT

Bell Labs has enjoyed a groat reputation for creating stellar research, while AT&T had a reputation for being slow or unable to bring much of it to market. How are things different under the Lucent regime?

At Bell Labs there was really no great motivation to drive the engine of innovation to produce products for a marketplace where depreciation schedules were long and competition was marginal. All that's changed today. Now the speed of change in telecommunications rivals or surpasses any industry in the world. And if you don't take advantage of the creation that takes place in R&D, then by definition you fall behind. So, the fact that competition exists, plus our drive to grow the business, has spurred a tremendous release of energy.

What does that mean in terms of R&D?

Lucent is a start-up company that's just two years old. Analysts suggest that we may have $30 billion in sales this year. We're going to spend in excess of $3 billion on R&D this year. We've tied our research budget to our growth in sales. So if our sales were to grow 20 percent this year, the research budget would grow 20 percent.

One percent of sales is dedicated specifically to research and the rest of that R&D budget goes to development. It is fundamentally important that research grow to give us the opportunity to hit the ball out of the park in the long term rather than only focus on the obviously important elements of developing products for today, tomorrow, and the coming year.

What's your view on the observation that the needle has shifted towards development, away from basic research?

Today's environment - where the amount of research is determined by the marketplace rather than by government funding and the direction of that research is determined by commercial concerns and corporate strategies - is in fact a beneficial one, an improved environment. Given the change in tensions of the world, we've seen the diminution of attention towards research that would support the military. People are focusing their research dollars on services and products that have broad and long-term commercial value. And that's offered us an opportunity to stand on the shoulders of giants, generation after generation - an institutional learning process.

More companies are going to be taking advantage of this need to move into the long term. They're going to blur the distinction between development and research. Some of the work that's going on today under the moniker of development is actually quite forward looking.

How do you measure how much you are getting for your R&D dollar and determine that it's being best spent?.

We track the percentage of our business volume that is coming from products that are new to the market in the past year. Day by day, more of our business volume comes from products that are not only new to the market but products that have a relatively short half life. And we look at the interval between the time of creation or original innovation and the time the product gets to market. There's been a dramatic change in that at Lucent that is directly linked to our ability to increase the speed with which this business is gaining share. For example, in eight months from concept to product we introduced our server that enables voice over the Internet.

What's over the horizon for the convergence of communications?

Beyond the notions of convergence of voice, data, and, ultimately, video, we've got a whole set of tectonic plates shifting simultaneously. You've got groups of customers creating primary demand, saying, "I want what I want when I want it." At the same time, legislative and regulatory changes are taking place in the U.S., and that virus is spreading globally and intensifying the competition among service providers at a rate that just a few years ago would have seemed unimaginable.

All these things are coming together and changing the way people gain information and make decisions. Whole industry segments are being cast aside or reformatted, and new ones are being created on the foundations of what previously were leading companies. If you are an adrenaline junkie, a person who truly likes to see a dramatic change taking place at a fundamental level, it's the best industry to be in and the best time to be in it.

What sort of new technologies are we likely to be seeing in the future?

In most instances, we are seeing extensions of technologies that have been around for some time. The transistor is now 50 years old and its impact is exploding in front of us every single day. Some megatrends will make a big difference. Microminiaturization - the ability to pack more power, intelligence, and storage, into ever smaller spaces - is one that will enable an array of specialized devices for information. Beyond that, photons are becoming more prevalent than electrons. You're going to see a constant movement towards the distribution of information using pulses of light that have been used for a long time in fiber optic communication, a specialized application that's almost pedestrian now.

What you have here is more and more information capacity traveling over these networks of light and giving greater and greater capacity for people to be able to receive and sort through massive amounts of information.

Beyond that, one of the big things that we see would be new, more facile user interfaces. Today, to a great extent, we're getting information access and retrieval through a keyboard. Perhaps the most useful user interface might be human interaction through voice recognition and response, but not always. You don't want to use a voice input or recognition when information isn't appropriate to be shared at a given moment in time. So it does have its place and it will grow in importance as the digital signal processors are able to more fully comprehend natural language.

We are also likely to see breakthroughs in wireless technology follow the same path of capacity as fiber optics or optics overall over the recent generations. Not only would that enable new kinds of devices - small wireless notebooks, PCs on your wrist, wearable computers with wireless connectivity, or cutting that tether - but you could actually see a dramatic economic impact for the communications industry where infrastructure no longer has the same implication. Those technologies would enable broad band wireless data for information access and communication capability to be put up very quickly. And this would offer an economic challenge to those that have the current franchise that is wire speed bound, and upset the status quo that's now held together by investment, by great marketing, and by brand.

Should people who've got a big investment in wires in the ground be worried?

Everyone worries, whether it's this generation of wireless facing a next generation or the crossover effect where you can handle massive amounts of data in wireless. In disk drives, for example, we've seen that the previous generation's leader is not necessarily the next generation's leader.

The notion of the innovator's dilemma is real. You have to be willing to recognize that the half life of your technological investment is reducing. You've got to be willing to cannibalize your own offers in the marketplace and your own technological base, and be willing to make investments in new generations of technology at a rate and at a level that you would not have done in the past when competition was less and technological introductions were slower. For many in the industry, there are more uses for funds than there are sources available.

Five or 10 years from now, will we still worry about bandwidth?

Within 10 or 15 years, the issue of bandwidth will have receded to a great extent, but will not go away. Today's screaming about bandwidth is partially a function of limited access to what is substantial bandwidth. So we have fixed the access problem by speeding things up. But it's also a function of applications that would use a great deal of bandwidth not being built today because there's no sense building them until there is more bandwidth. As bandwidth becomes abundantly available, new bandwidth-hogging applications will be built. So as more bandwidth comes in, more bandwidth demand will come in on top. We'll take care of the current consumption rates, but I believe that it continues beyond that.

One thing that will disappear, though, is the notion of an economic proposition based on time and distance. And that's a big change because a lot of economic models have been built on that. What you will have are prices that are micro-cents per minute for large-scale customers, who can them use that bandwidth capacity in ways that offer a competitive advantage.

How does the company use its various alliances and partnerships to leverage some capabilities and not others?

Given the panoply of market segments that we're involved in, any notion that one size fits all is certainly a fallacy. No firm in the world, no matter how comprehensive, no matter how good they might be, has cornered the market on intellectual property development. There are wonderfully bright people all around the world, and in today's environment you've got to tap that diverse resource pool. We're trying to find an opportunity that provides an outlet for intellectual property. For instance, promoting ventures we have here - fingerprint identification, various software capabilities - that are not mainstream to our mission or vision of leadership in communications networks and over time, spinning these off to create good, independent businesses. We provide seed capital, management guidance, etc., but have no cookie cutter approach to how that can be done.

We have a new venture capital corporation, Lucent Technologies Venture Partners in Palo Alto, that invests in start-up companies in pre-product stage, looking for great, innovative ideas. Our objective is to have those people see us as a firm to which they'd like to be magnetized, not owned by, but working closely with.

We've got efforts at joint development, such as the recent decision to work with various computer companies on the creation of a standard for universal access on ADSL or ADSL lite, XDSL. As a result of meeting and hopefully providing guidance in the development to evolution of that standard, we can then deliver our leading-edge modern technology at 1.5 megabits.

Lastly, we are very willing to complement what we do here in terms of organic development and growth, by acquiring companies that are core for us. These are all different ways to fill out what we do in providing end-to-end networks and comprehensive product offerings to customers, rather than simply assume that we're going to do it all on our own because we know everything, or to suggest that we're giving up the ghost and we're going to simply acquire technology.

What sort of process do you go through when you come up against something that may fit your constellation?

The end game is the marketplace, serving the customers and besting the best of the competitors out there. You've got to recognize that there are things that we can do very well and there are other pieces that simply must be added to this wonderful mix that give you time-to-market advantage. With that external benchmarking approach, you do away with the issue of "Is ours better?" It's not relevant unless it's contributing to the attainment of those goals. That takes the issue off the table. Since there are more uses than sources of funds, we've got to make some choices. How we're able to bring all of the resources together - through partners, acquisitions, and organic development - is what it's all about.

A WIRED, WIRED WORLD

Observers say that data networking is the weakest link in your chain of armor.

We're the new kids on the block in terms of data networking. We are flattered in a way because the leading companies in data networking today are pointing at us and saying we're the looming threat. We know the enormity of the battle we face going forward as we bring all our resources to bear on this. But to be recognized as having the capability of doing this is buttressing up our feeling that we're on the right track. We understand networks. We know how they're going to work. And we can see how these complex networks are going to converge to address both the voice and data world and ultimately the video world.

What do you need in terms of skill sets or technology sets to achieve this goal?

We always hold out the possibility that we could acquire additional companies for their technology, as well as for the great talent that they have that augments what is here in Lucent. One of the big issues today is the lack of talented people willing to come in the morning, put black under their eyes, and knives in their mouths and go out there and be absolutely committed with a sense of ownership to be leaders in this rapidly evolving world.

It's a treadmill. The better you get, the more customers you serve; the more people you need, the more people are attracted to you. There is no goal line. There is no finish point. The goal keeps receding ahead of you as customers get more demanding and competitors get tougher every day.

What are your for global growth?

Early in this century, the preceding company that has now become Lucent had about 25 percent of its business out. side of the U.S. and then decisions were made to step aside and to focus exclusively on the U.S. market. So we are brand new in the market outside the U.S. From that nonexistent position, in a short period of time, we now have 25 percent of our business outside the U.S. against really formidable competitors who have longstanding relationships and have served those customers well. We're coming in, taking advantage of deregulation or liberalization, taking advantage of our technological excellence, knowing well how networks work and if they don't work, how to fix them, great people, building relationships. We are not at all satisfied with where we are, but the upside for us is a whole new set of opportunities and customers to serve out there. The U.S. is a great base and growing rapidly for us. But beyond that there's a great chance for us to continue to accelerate our growth.