Why Did The Crisis Happen? One Does Not Need To Look Too Far Back
n this age of manifestations of human greed, a financial crisis partly attributable to bank manager´s quest for short term profits: one wonders the origins of such behavior and the old adage of “history repeats itself.” One does not need to look too far back in history to understand that all financial disasters have the same set of usual suspects: an overzealous CEO who is fixated in conquering the world, compensation based on incentive pay that relies on short term profits that mitigate manipulations, shareholders and other government officials who fail to recognize “red flags,” and who act as primary cheerleaders for the company up until its demise.
The company that I refer here is Nortel, which, in my opinion, witnessed the most spectacular rise and fall of any public corporation. Although overshadowed by other peers such as Nortel and Worldcom, I believe Nortel´s story far exceeds the latter companies because apart from its disasterous failure, its rise from a small regional player to the global name in telecommunications was like no other. From a small regional players up until the arrival of CEO John Roth – the rise of Nortel over the years 1998 to 2000 came straight from a story-book fairytale. At its peak, Nortel was a giant corporation. In July 2000, at the height of its success with a market capitalization in excess of $350 billion Canadian dollars, it accounted for more than 37 percent of the Toronto Stock Exchange Composite Index value and ranked among the largest firms in the world.
As a diversified company focused primarily on telecommunications, Nortel seemed invincible. Commentators were pleased with its “strength across the board in its product markets” and its focus on the fastest growing wireless and broadband communication segments. Its particular expertise – in wireless and broadband communications - allowed it to post very impressive revenue gains in product segments where it was a relative newcomer. Nortel seemed poised to exploit new Internet technologies and an expected wave of international deregulation in this sphere. Using an aggressive acquisition strategy, Nortel grew quickly and well beyond North America. As a result, analysts praised what they perceived to be “solid, sustainable growth” from large R & D expenditures fueling the ‘perpetual surpassing ‘of earnings expectations. When one compares the earnings surprises of Nortel with respect to all the technology players in the industry (an aggregation of 18 other firms, including Ericsson, Cisco, etc). It is evident that Nortel consistently beat analyst expectations by a few cents, hence, keeping a perception of “invincibility.”
Nortel’s share price more than tripled in four years. By mid-2000, it reached a peak of more than $200 Canadian dollars per share. Starting from a strategy of being in every high-growth area in telecommunications, and benefiting from tailwinds due to regulatory and market conditions, Nortel tripled its sales and multiplied its pro forma operating profits several fold within five years. Consequently, the media proclaimed CEO John Roth a man of boldness and vision in possession of a Midas touch. This mania also spread to the analyst community, as the market grew increasingly reliant during the proliferation of the technology sector in the late 1990s. Nortel greatly increased its institutional investor ownership as more analysts hailed its performance. Analysts grew lazy in their assessments during this time. They justified high priced acquisitions such as the $US 3 billion purchase of Qtera, a firm with no sales, failed to critically scrutinize accounting changes that had revenue impacts and cheerleaded questionable spin offs. Meanwhile, government regulators draped the company with the Canadian flag as a symbol of national economic vitality. In short, everyone wanted to believe in the Nortel supernova.
Nortel’s fall from grace came swiftly and on many fronts. Beneath the unsustainable rate of growth and earnings lied massive accounting financial irregularities where results had been seriously manipulated for some time. Not only could analyst targets no longer be achieved, but good will had to be reinforced. For years, a cloud would hang over accounting results reported by Nortel, including the perennial belief that the company had “cookie jar reserves” useable to normalize results. Ultimately, Nortel announced several restatements, including the largest one in Canadian history.