The market seems to be in a forgiving mood these days. Nortel Networks Corp., the lightning rod of investor anger over much of the past year, has surged recently, riding the fresh wave of optimism washing through the shelled-out technology sector.
Analysts are starting to stamp "strong buy" ratings on the stock again and Nortel's new CEO believes the company has found the bottom, now that it has escaped a potential financial crisis.
While the stock is trading hands at a 10th of where it was at its height, conservative analysts still think it's expensive. But investors don't seem to be paying them much heed.
Even if Nortel is overcoming the credibility problems it endured after issuing a bombshell profit warning earlier this year, it will still have to answer its critics. Lawyers acting on behalf of angry shareholders will be filing their complaints with the court in New York this month, kicking off a long, grinding process that will scrutinize the company's financials, press releases and public statements.
Such lawsuits are not unusual in the wake of sharp falls in stock prices, and they rarely do serious damage to a company's finances. Nortel says the claims are unfounded and that it will defend itself rigorously. But even if it emerges from the courts unscathed, there will always be questions about how Nortel, the crown jewel of Canada's technology industry, could have come to be such a prominent victim in the tech market catastrophe last year.
The company, which would not comment on this story, has always maintained that it was just a victim of a drastic economic downturn. The story isn't quite that simple.
The Equity Culture
There was a time when when John Roth, Nortel's former president and chief executive officer, was everybody's hero, when all and sundry were profiting from the relentless rise of Canada's technological crown jewel. After the fall, Mr. Roth became the focal point for burned investors who felt they had been misled. The fact that Mr. Roth sold millions of dollars' worth of Nortel stock near its peak still rankles, given what transpired after his trades.
CEOs of established companies usually don't discuss their companies' stock, partly out of a sense of propriety, and partly because the stock market is an inscrutable beast that can land them in trouble. The same doesn't apply to fledgling firms, especially the ephemeral concerns that came and went in the great technology bubble.
Mr. Roth's approach leaned more toward dot-com entrepreneur than blue-chip captain of industry. In the fall of 1999, the overseer of a company with $22-billion (U.S.) in annual sales boasted to the Ivey Business Journal that Nortel "has split its stock four times over its history, and I've split it two of those times."
In October of last year, right after Nortel's stock price tumbled 30 per cent following the company's warning of lower sales, Mr. Roth proclaimed it "a great buying opportunity" on U.S. and Canadian business television networks.
A profile of Nortel's star CEO in the March, 2000, issue of Report on Business Magazine opens with Mr. Roth discovering that his company's market capitalization had, for the first time ever, surpassed that of archrival telco Lucent Technologies Inc. of Murray Hill, N.J.
It also relates the story of how another rival, Cisco Systems Inc. of San Jose, Calif., once paid $7-billion for a company that had no revenue, a deal that - to Mr. Roth's surprise - drove his company's stock price down while Cisco's rose.
Lesson learned: "That's the new world of acquisitions," he told the magazine. "That's the new math." The profile ends with Mr. Roth checking Nortel's stock price on his browser.
Tellingly, Nortel and some of its peers also used television to boost their profile. Telecommunications networks are hardly consumer staples that benefit from mass-media marketing, and yet there were hip, prime-time commercials touting the wonders of optical networks.
"They were advertising their stock," one company watcher alleges. "It's as simple as that."
Nortel also cultivated an equity culture within the company, not only through the usual practice of issuing stock options but also modelling some bonus systems on stock market themes.
Screens at the company's Brampton headquarters flashed updates of Nortel's share price. This equity culture, insiders say, created a competitive environment that helped Nortel's highly regarded staff develop and sell cutting-edge products. It also kept them thinking about their holdings.
If Nortel believed in the power of its stock, however, it didn't always treat it with respect. In the four years of Mr. Roth's reign, from late 1997 to October, 2001, the company spent hundreds of millions of shares on acquisitions and doled out millions more in stock options to employees, board members and executives. This practice was rampant in the high-tech world, but some think Nortel went too far even by that standard. The Ontario Teachers Pension Plan Board has been a harsh critic of Nortel's generous option plan and has pressed the company to change it, to no avail.
Critics of options plans say that dangling such potential stock riches in front of managers is not in the best interests of a firm, especially given the relative ease with which financial results can be finessed to show healthy performance in the short term at the expense of longer-term success.
"Companies don't go bankrupt because of earnings management, but if they have to resort to it, it's usually because the earnings aren't sustainable," says Anthony Scilipoti, an analyst with Veritas Investment Research and an early critic of Nortel's financial performance.
Nortel's acquisition strategy severely taxed the company's capital stock. The company spent 972 million shares on acquisitions and assumed stock option plans amounting to a potential 161 million shares between early 1998 and early 2001. Together, these extra shares added more than 50 per cent to Nortel's diluted stock outstanding. Most of the firms acquired, however, had no sales. While the value of the stock issued was $32.1-billion, the total tangible net worth of the companies acquired was only $1.1-billion.
Conservative shareholders were not happy, but if the company didn't bat an eye, it was because the "new math" of acquisitions was working its magic: Investors rewarded each acquisition by bidding up the stock. If the market measured success, the gauge was red-lining. The options moved deeper into the money.
By aggressively writing off most of these investments in the past two quarters, Nortel has acknowledged that it overpaid for them. It wasn't the only technology company to make such admissions, but its writeoffs were among the biggest.
The company, along with its boosters in the analyst community, used to dismiss such "paper" losses as insignificant. But just as debt has a cost - the interest rate - so does stock: the return investors expect to make. Given the risks Nortel was taking, that cost was high. In hindsight, of course, it's easy to criticize. But even at the time, there were doubts. One of the owners of an early Nortel acquisition says the purchase of his company was "dubious. There was a lot of hype back then."
With so much riding on the shares - employee prosperity and morale, the goodwill of the investment community, the dream - the pressure to keep the stock price healthy must have been intense.
Besides perhaps breaching unwritten protocol, there is nothing technically wrong with a CEO enthusing over his company's stock. Nor is there anything technically wrong with using reams of shares to buy dozens of companies with no revenue, besides the excellent odds that it will prove a colossal waste of shareholders' money.
But where Nortel's judgment is brought into question is when these two experiences are viewed in the broader context of what happened in the industry.
The great telecom bubble was inflated by a confluence of events that date back to the mid-eighties and early nineties, when governments started to introduce long-distance competition to the telecom industry. The deregulation process took several years and was largely completed by the mid-nineties, with rules allowing competition in local, long distance, mobile and data services, telecom consultant Mark Goldberg explains.
The Internet really got the market drooling. Entrepreneurs already coveting the profits of sleepy phone monopolies now had even better reasons to get into the communications business: the untold revenues a digital society might unlock. They had the plans, and now - thanks to an ample supply of risk-tolerant seed money - they had the means to get started.
An abundance of capital, a lack of skepticism and a sexy story that's easy to believe even if the outcome is impossible to predict make for a dangerous combination.
For a while, though, life was beautiful for anyone involved in the sector. Nortel suddenly had a batch of new customers with lots of money to spend. Traditional customers were also beefing up their capital spending.
When Mr. Roth took the helm at Nortel in late 1997, he inherited a company with healthy revenue and earnings growth and solid cash flow. But he and his team saw a way to make it grow faster yet, by buying their way into other areas of the networking world and chasing sales from the young, flush companies with New Economy business plans.
The apparent effect of Mr. Roth's strategy was startling success. From 1994 to 1997 - when he was named CEO - Nortel's compound annual revenue growth rate was an enviable 20 per cent. From 1998 to 2000, it was an astonishing 25 per cent. For one Nortel salesman, that frenzied period culminated in September of last year, when he says his phone was ringing off the hook at all hours. The peak was when he got a call from a washed-up entrepreneur who wanted a slice and thought he could talk Nortel into financing his plans.
"The guy was on welfare," says the salesman, who unfortunately discovered this only after reviewing a hastily concocted business plan in the hopeful tycoon's kitchen.
But well before the peak, there were skeptics who saw through the rosy optimism and tried - largely in vain - to point out that deregulated industries always follow the same pattern: Competition spurs capital spending, which creates excess capacity, which guarantees price wars, which kill off the weak and damage the industry, stifling profits and choking off new investment. Those who supply the industry get nailed by collateral damage.
By the beginning of 2000, the doubts were confirmed. Big money investors realized that the demand assumptions in New Economy business plans were far too optimistic. They reacted by cutting off the funding, the fuel driving Nortel's phenomenal growth. In spite of that, Nortel would maintain its aggressive forecasts for almost a year.
John Cadeddu is a managing director with Duff Ackerman & Goodrich (DAG), a private equity investment firm in San Francisco that specializes in communications. DAG was an early investor in so-called competitive local exchange carriers (CLECs), companies that hoped to do battle with incumbent phone companies.
Mr. Cadeddu says it was widely known in the industry that telecom and Internet firms had been shut out from financing after the first quarter of 2000.
"Look at the money flows. ... How many high-yield money flows went to CLECs and broadband after that?" he asks rhetorically.
The answer is distilled in the cash flow statements of the CLECs themselves. Axxent Inc., for example, was a Toronto-based CLEC whose brief life span neatly traces the telecom bubble and confirms what Mr. Cadeddu observes. In the entire 15 months leading up to the first quarter of 2000, Axxent managed to raise $148-million (Canadian) to build its network. In just the first three months of 2000, Axxent raised another $170-million. Then the doors slammed shut in its face. Axxent essentially never raised another dime and it failed earlier this year. The company, whose working capital had shrunk to $36-million by the end of 2000 from $205-million nine months earlier and whose quarterly revenue never exceeded $23-million, had debts of $70-million. Most of the loans had been provided by Nortel in December, 2000.
There were others. Cannect Communications, a private firm, also failed earlier this year, petitioned into bankruptcy by its creditors, one of which was Nortel. Highpoint Communications was forced out of business after Nortel repossessed its equipment. These experiences were the rule rather than the exception in the CLEC industry.
Although most investors were blithely oblivious of the drying capital pools, some of the equipment makers were not. Other equipment makers acknowledged the industry's downturn months before Nortel.
In October, the company warned that its revenues would fall far short of forecasts for the year. The company denied that it was because of softening demand, insisting that it was a problem with supply.
Summed up, all these fragments of inconsistency fuel the suspicions of those who question how Nortel could not have known about the drastic downturn in the telecom sector prior to February of this year, when it finally admitted it.
If the height of the financing boom came in the first quarter of 2000, the height of the spending boom came in the few months that followed. That is not to say, however, that Nortel and other suppliers found it easy to score sales as the year wore on.
"Starting in the second quarter of last year, Nortel got way more aggressive. You could tell sales guys were under tremendous pressure to book sales," says a U.S.-based venture fund investor.
In the case of the firms this investor had taken a stake in, that meant increasingly generous financing terms. Like all of its peers, Nortel engages in vendor financing, which involves selling equipment on credit. It can also include what's called working capital financing, whereby the lender also lends the customer funds with which to run its business. Actual and potential customers say Nortel's financing offers reached as high as 130 per cent.
Vendor financing can be a valuable tool. An upstart networking company that survives and thrives is unlikely to change suppliers as it grows. Being the first one in the door, then - assuming the firm would thrive - was vital for the Nortels, Lucents, Alcatel SAs and Ciscos of the world, all of which lent generously, especially as 2000 sped by.
Not playing the game meant possibly losing out on future business, and in a competitive industry where scale matters, that's not an option. But such financing can also be extremely dangerous if the risks aren't respected, and that's what happened to Nortel and its rivals.
When a vendor-financed sale is made, the company is allowed to book the revenues as it would if the sale had been cash. Accounts receivable, an asset account on the balance sheet, are also booked. The company periodically assesses how likely it is to collect its receivables, and, when in doubt, it takes a charge by raising its provision. The provision, in other words, is a measure of the riskiness of the client.
In 1996, Nortel's provisions as a percentage of long-term receivables were only 3.4 per cent. In 1997, that figure doubled. In the next three years, however, the figure soared to an average of 20 per cent. The provision often spikes up in the fourth quarter as well. Nortel was taking on increasingly big risks with its financing. Other equipment vendors were, too. However, the venture capitalist says Nortel was one of the most aggressive.
The more a company sells on credit, the lower its cash flow will be. Although Nortel announced a 2000 profit of $2.3-billion, its operating cash flow was slightly negative.
Nortel's cash flow situation might have been worse if not for the Export Development Corp., a Crown corporation. The EDC doesn't reveal details of its dealings, but it does provide financing for some Nortel customers. That's good news for Nortel's shareholders, even if it might not be for taxpayers.
Just as taxpayers might like to know more about EDC's dealings (the corporation recently improved its disclosure), investors would have liked more details about Nortel's financial health.
Nortel's reported profit wouldn't confuse sophisticated investors - although some of these complain that disclosure rules don't provide enough information on, say, vendor financing. But Nortel's so-called profit fooled plenty of less experienced stock buyers. While there are strict rules defining profit in official financial statements, companies have plenty of leeway in their communiqués. Nortel's version of profit excluded a number of expenses.
As the company has taken huge charges to write off some of the receivables added to its books last year, last year's profits are in a sense this year's losses.
The fallout from this story is by now well known. Investors lost billions and Nortel - the crown jewel of Canada's technology industry - is a shadow of its former self, having shed half its work force and much of its productive capacity.
Much of the flush executive suite decamped once Nortel ran aground, which also raised suspicions.
Embittered investors, large and small, consider the evidence available to them and have trouble understanding why Nortel did not tell them more about industry conditions.
"There were clearly signs." says one money manager with ties to the telecom industry.
In spite of these suspicions, there are also indications that Nortel thought all was well. Mr. Roth may have cashed out a king's ransom in Nortel options last year, but he still owned hundreds of thousands of shares and options at the beginning of the year, a fact that isn't often reported. And Nortel's financials show that the company was still investing heavily up to the first quarter of this year.
Talk to people who lived through that heady period, and you get a sheepish explanation of how the telecom bubble popped.
"The textbook assumptions outpaced the field assumptions," says Bill Baines, a veteran of Canadian telecom and the former CEO of a now-defunct CLEC. "We grew too fast. We forgot some of the basics."
Entrepreneurs are dreamers, and by nature, they have trouble letting go.
"I think there was a lot of denial," Mr. Baines says.
Investors also have to shoulder their share of the blame. But increasingly, the ire is zeroing in on the company's directors, who critics say were ultimately responsible for pouring cold water on the executive team.
"Investors needed to hear from that board, and from the chairman of that board," says corporate governance authority J. Richard Finlay.
The source of the compensation might be revealing - Nortel directors are partly paid in stock options.