The Truth About Nortel, Cisco and Lucent
From TheStreet.Com/James Cramer.
What happened to Nortel and Lucent and Cisco? What really went wrong? This multipart piece is designed to help you understand what the term "secular" is -- as in "secular decline" -- because that's what I see going on here.
First of all, there are two kinds of declines: secular and cyclical. A cyclical decline is usually an inventory decline. A secular decline is something longer-lasting that doesn't reverse. We saw a cyclical decline in oil for several years as OPEC pumped too much. When that inventory glut wore off, we had a cyclical snapback, which exists today.
A secular decline is quite different. There was a secular decline in buggy whips after the combustible engine came onto the scene. There was a secular decline in black-and-white televisions after color televisions got cheap. There was a secular decline in train use after cheap trucks and cheap highways came into use. You can still make money with trains.
You can't make much with black-and-white televisions. You can't make anything with buggy whips. Now, let's compare these nonidentical twin declines to telecommunications spending.
For many years, the equity and debt markets were incredibly receptive to different phone companies that chose to raise money. If you were a financial whiz, you could snare an AT&T guy (heaven knows there were enough of those around), go to an investment bank and raise equity, bonds and convertible bonds (bonds that convert into equity if the stock moves up) at very advantageous prices.
You could do that for several reasons. One was that the demand for telecommunications seemed unlimited. Second was that the telecommunications industry was allegedly deregulated by the Feds in 1996, giving anybody a chance at competing against the old regional bell operating companies. And third was WorldCom. We forget now, because WorldCom has been such a dog, but there was a time when this stock was the greatest wealth creator of all time. People wanted to get long the next WorldCom in the worst way.
So dozens of worst ways were created.
More than $300 billion got raised by this one industry alone. That is much, much more than the amount of money that the dot-coms raised. Much more. We began to believe that it was possible that we could have as many as 14 different telephone companies in this country. Plus, all of the phone companies in Europe went through a similar explosion.
Every one of these companies had to raise money to buy equipment. Now we all know that the dot-coms had to go buy Sun Microsystems servers and Vignette and Art Technology Group software, and they had to pay Exodus and a couple of other toll-takers.
When these phone companies raised money, they had to pay Lucent, Nortel and Cisco, as those companies made the giant systems that these phone companies needed to compete with each other. Remember, every one of these phone companies was competing for the same business. Some of them could afford to buy quicker, better equipment than others. But for the most part they needed stuff from these three (as well as Corning and JDS Uniphase).
Imagine you were a salesperson at one of these three companies. You read that company after company after company "got funding" to build out its network. That meant that your company had to get that business. These were giant pieces of business that were up for grabs. Often the pieces of business were so huge and staggering that you had to compete on more than just hardware and software. You had to compete on financing. You had to make terms, give master leases, do what was necessary to get the business.
Salespeople at these companies saw the bonanza. They pursued every phone company, including some that didn't have funding -- just a promise of funding -- and they sold them equipment. With so many companies raising money at the same time, and so much money available, it seemed that the good times would last forever. After all, we know that more and more data were being pushed every day, and if a company didn't order the latest iteration of equipment, it could be outclassed by others.
Then, last summer -- yes, it was that recent -- several warning signs occurred. First, GST Communications and ICG Communications fell on hard times. Oh, sure, you could say that ICG's problems were simply the shenanigans of bad management and that GST was a crummy company. But if the industry were as robust as we thought, even the relentless pursuit of Vogue's Anna Wintour by Shelby Bryant (the super-slick salesman head of ICG) wouldn't have derailed things. These companies were having a hard time getting companies to pay -- and getting new customers without giving away the store.
Second, the rollout of new lines, particularly high-speed lines, ground to an obnoxiously low level because the central office, where all lines have to go through, got filled up and the incumbents, the BellSouth, Verizon and SBC Communications, didn't exactly knock themselves out to help the alternative carriers. That made installation of all of the equipment much more expensive than the geniuses behind these companies thought it would be. They figured they could litigate it -- many of them were run by lawyers -- but this was just an old-fashioned issue of habit that couldn't be changed in time, and many of these alternative carriers fell by the wayside.
Third, the Fed raised rates six times, which made it more difficult for companies to get funding. Lots of these companies felt they had two ways around their funding dilemma, a booming equity market and a booming market for high-yield debt. But the Fed's increases really killed both markets. Without an equity market, these alternative carrier companies had to try to raise money in bonds. However, the people who sell bonds, the Morgan Stanleys of the world, lost a lot of money handling the ICG-type of paper and their customers and they were in no mood to raise any more. The market got shut down for these companies.
Finally, the tremendous creation of companies that were meant to rule the New Economy -- all of which needed these telecom companies and were the willing clients of them -- stopped. Last March, when the dot-com bomb went off, it just stopped. Without a plethora of new customers, we didn't need as many phone companies as we thought we did. Without an equity market that would give cash to any Tom, Dick and Harry.com, the customers stopped paying the bills. The growth went from being phenomenal to just OK. Remember, though, there is growth. This is not a no-growth game; it just doesn't have enough growth to keep all of the players alive.
Now we come to the tricky part. All during the boom, the Lucents (LU:NYSE - news), Ciscos (CSCO:Nasdaq - news) and Nortels (NT:NYSE - news) could not make enough equipment to meet the demand. They could not get the components of their equipment as shortage after shortage developed for all kinds of semiconductors and capacitors that went into the their product.
Of course, that pissed off the clients -- the phone companies -- so the Ciscos and Lucents and Nortels had to stockpile components, or order more components than they should have, sometimes double- and even triple-ordering to be sure they had a reliable supply of product.
In the meantime, the companies that make the chips, the suppliers to the Ciscos, Lucents and Nortels, didn't know what to do either. They added to capacity and built more and more specialized components for these companies. That meant that they, too, had to overorder all sorts of fabricating and testing equipment to be sure they could meet future demand. (That's Applied Materials and Credence and KLAC-Tencor.)
Still, until the fall, the shortages continued. Even after the carnage in the bond market told you what was going to come. I managed to sidestep the carnage not because of my contacts in the Valley -- where everybody was bullish as all get-out -- but on Wall Street, where buddies of mine indicated that the junk bond market would not allow any more money raised for telecommunications work. You could have found this out, by the way, if you had research coverage at Lehman Brothers, as Ravi Suria explained all of this to customers of his firm. You could have also found out from talking to Sanford Bernstein, where Paul Segawa pretty much outlined everything that would occur in September -- because he, too, had good contacts in the financing community.
So, when the cracks first appeared, when the customers first had a hard time paying, others took the slack and the Ciscos of the world continued to order like mad not to disappoint. The forecasters at Nortel, in particular, were thinking that things were as terrific as all get-out. That meant more and more components kept being ordered.
If you were Kevin Landis at FirstHand Funds or Malcolm Fobes at Berkshire Technologies, you only saw these orders, and you continued to believe that your companies had tremendous visibility.
That, however, was just plain wrong. Cisco and Nortel and Lucent were simply overordering. |
