During their recent episode, Taylor, Carlisle, and George Livadis discussed From Internet Backbone to Bankruptcy: The Cautionary Tale of Nortel. Here’s an excerpt from the episode:
Jake: [sighs] All right. Let’s do it. This one might actually fit in with some of the conversation about some of the bigger companies. This is a little story that’s a dramatic rise and fall of one of Canada’s most loved and eventually reviled companies. This company called Nortel. At one point, 75% of North America’s backbone, internet traffic, was traveling through Nortel’s networks.
But let’s rewind the clock a little bit. Alexander Graham Bell, Scottish immigrant, moved to Canada with his family. Supposedly, he wrote the underlying mechanism of the telephone at his parents’ home in Ontario. Eventually, he famously sent that live message to his partner, Watson, while he was in Boston. He always wanted to live in the US. It wasn’t Canada. Yet, somehow Canada still claims that they invented the telephone sometimes. I think there’s a little bit of dispute over that.
So, there was this company, Bell Canada, which was a relative of the behemoth monopoly AT&T had in the US. They had this little branch plant in Montreal where they made telephones. It was called Northern Electric and Manufacturing Limited. There was also this Bell Network Labs, which was a copycat of version of the US’ Bell Labs. So, this is up in Canada as well, BNL. BNL ended up inventing this digital switch, because AT&T really was complacent with their monopoly. They didn’t want to render billions of dollars of their existing equipment obsolete. This is typical innovators dilemma.
BNL was early in commercializing fiber optic cables. At the same time, we had deregulation of the telecom sector, meant that all these companies were racing to get into telephone, cable TV, even this newfangled thing called cellphones. There was this flood of capital into the industry. The digital switching equipment industry was dominated by this company called Lucent, which was actually the new name of Bell Labs when it was spun out of AT&T.
And so, second in line was Nortel, and then third was this startup in Cali called Cisco. So, fast forward, where in 1998. Nortel announced that they’re buying this switching company called Bay Networks for $9.1 billion, which was a lot of money back then. I know now that’s like rounding error, but–
Tobias: Mid-cap.
Jake: Yeah, mid-cap, small-cap. Bay was Cisco’s biggest direct competitor. Except they didn’t use money to buy them, of course. They bought the Bay Networks for shares. So, they created $134 million freshly printed shares. Don’t smudge the ink. This then caused Lucent to buy Ascend Communications for $20 billion. Not to be left out, Cisco went on a buying spree, they bought 64 companies over the next year.
Nortel then went on a shopping spree of their own, buying one company per month. By the year 2000, the Ottawa region had 1,000 companies employing 75,000 people, one in five of them belonging to Nortel. At one point, one in five engineering grads in Canada were hired by Nortel. And if you had a PhD, it was one in three. So, it became this tech corporate Disneyland. Lacks dress codes, no time clock, corporate perks, huge parties every other week. The popularity of Nortel on the Toronto Stock Exchange completely exploded.
In 1998, Nortel shares, they were around 5% of TSE 300. One year later, it was 8%. Three months after that, it was 16%. Nortel’s revenues, meanwhile, were growing all along, mostly through M&A. 26% in 1999 alone. The only other thing they were better at growing was handing out shares. So, they notorious for the stock options. They printed 161 million new shares in the late 1990s. Over a two-year period, they spent $30 billion on M&A, but $22 billion of that was paid for with shares.
The increase in shares came with these restrictions though. So, it would typically be 6 to 18 months where they couldn’t sell. The TSE 300 index, because it was based on a weighting of market cap, they used that number of shares for the allocation, yet the float actually wasn’t really there. So, you ended up with this squeeze that was happening effectively.
So, in 1998, shares out for Nortel were $500 million. Just to give you some context. Within two years, it was like $3 billion. Like, they 6X the share count, which then made the index have to increase their amount. At the height of the dot-com bubble, Nortel finally passed Lucent. And in the summer of 2000, Nortel made up 38% of the entire Toronto stock Exchange.
So, just think about the insanity of that. One company representing 38% of basically Canada. At the time, this was huge. Great news for Canada, who has had a little bit of a chip on their shoulder about being the little brother in the shadow. This really is like the battle of the Bell Labs. In this instance, the Canadian JV team of Bell Labs was beating Claude Shannon’s OG varsity team at that point. That’s the implication of Nortel passing Lucent. At its peak, it was a $400 billion market cap, which today’s dollars was $720 billion, which is actually still pretty good. It was the nineth most valuable company in the world at that time.
Now, here’s where things started going a little off the rails, as you would imagine. They invented their own accounting term, which they called earnings from operations. Now, of course, they still report a gap and everything, but this was one of the early versions of community adjusted EBITDA. [Tobias laughs] They would just basically leave out. It was a lot of pooled accounting, if you guys remember that, some of those things that happened in the late 1990s that eventually was made illegal.
Nortel wasn’t doing anything illegal there. It was just they were aggressive with their accounting. They would highlight the numbers that they wanted to highlight. By the way, comp all the management off of adjusted numbers, not off a gap. So, what’s interesting, of course, is the demand for all this broadband capacity– I’m sure, Toby, you can speak to this from your time, the things that you did in this space, even better than what I’m saying. But it was certainly growing, but just not like the most bullish analyst would predicting.
As those chickens started to come home to roost, like one week in 2000, Nortel crashed, and it fell even that one week from 32% down to 24%. So, when these things have these meteoric rises and they become huge, there’s a lot of space to come down. There were so many shares that were trying to be dumped at the time that the TSE was crashing, several times a day for technical glitches. They just couldn’t process so many people trying to sell. These reports would come out that fiber networks were only being utilized at 7% to maybe 15% of the total capacity. It was just incredible amount of overbuilding.
So, naturally, layoffs start. There’s empty buildings, empty parking lots. They’re selling things for parts. Eventually, it goes down 99% from the July 2000 peak to the October 2002. So, a little two and a half years, you’re pretty much completely wiped out. One-third of their acquisitions were complete write offs, full zeros. Eventually, they sputtered along selling assets. They filed for bankruptcy protection finally in January 14th, 2009.
By the end of the year, they were gone. It took then another 3,000 days for the final bankruptcy proceedings to finish, because it was just this dumpster fire morass of international courts, interested parties, pension plans. Everyone’s fighting over the scraps to carve up what’s left over of this at once was the nineth largest company in the world. The only people who really won this whole thing, the lawyers $1.3 billion in legal fees over that 3,000-day extravaganza. What a– [crosstalk]
Tobias: Good to see the lawyers win.
Jake: Yeah, happy for those guys to get one. So, anyway, we can try to look for lessons in this today. I don’t know, if this has some rhyming with Nvidia. Right now, Nvidia is 7% of the S&P 500 at $3.3-ish trillion market cap. That’s a pretty far away from 38%. Maybe we go there. There’s nothing that says we couldn’t. If that’s the lesson that you want to take away from this history, then I would say–
Tobias: Room to run. Room to run.
Jake: Yeah, there’s lots of room to run.
George: It’s getting started.
Tobias: It’s getting started.
Jake: Just stretching our legs.
George: Yup.
Jake: But I think if things get too extreme– Maybe there’s some other things to look for, is if you see Nvidia start to stretch on making lots of acquisitions, if you see them– maybe the accounting gets a little squishy. There’s lots of these little red flags that can come up and maybe just keep your eyes open along the way or overcapacity comes into the industry in a major way, which would not be the first time that that’s happened in the semi land. So, maybe just little things for you to keep your eye on if you are in long Nvidia.
Tobias: That’s a good one, JT. That’s an incredible fall down 99%.
Jake: Yeah, that hurts.
Tobias: But you couldn’t have shorted it either. It’s one of those ones that you can’t win long or short there.
George: Once it’s down 50%, then you short it.
Tobias: That’s when you short. Yeah. Oh, that’s tough. How do they end up in bankruptcy protection? Telecom must have been making some money through that period, know? Too much debt.
Jake: Too much debt. Just spending money on whatever. It doesn’t matter. Just throwing these fun coupons around that were shares. Just insane. Everyone wanting to get there as fast as possible. When you’re moving as fast as possible, you don’t worry about expenses.
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One Comment on “From Internet Backbone to Bankruptcy: The Cautionary Tale of Nortel”
Have you guys done any research into Nvidia’s off balance sheet financing/supply chain financing? Hard to find much information on that, but could be interesting to see if/how that has facilitated the company’s rapid growth over the past year or so.