Is Enron Overpriced?

More from Fortune

FORTUNE 500
Current Issue
Subscribe to Fortune

It's in a bunch of complex businesses. Its financial statements are nearly impenetrable. So
why is Enron tradin at such a hue multiple?
!y !ethany Mc"ean
March #$ %&&'
(E) *O+, -FO+./(E0 11 In 2ollywood parlance$ the 3It 4irl3 is someone who
commands the spotliht at any iven moment 11 you 5now$ li5e 6ennifer "ope7 or ,ate
2udson. )all Street is a far less lit7y place$ but there's still such a thin as an 3It Stoc5.3
+iht now$ that title belons to Enron$ the 2ouston enery iant. )hile tech stoc5s were
bombin at the box office last year$ fans couldn't et enouh of Enron$ whose shares
returned 89:. !y almost every measure$ the company turned in a virtuoso performance;
Earnins increased %#:$ and revenues more than doubled$ to over <'&& billion. (ot
surprisinly$ the critics are ushin. 3Enron has built uni=ue and$ in our view$
extraordinary franchises in several business units in very lare mar5ets$3 says 4oldman
Sachs analyst >avid Fleischer.
?lon with 3It3 status come hih multiples and hih expectations. Enron now trades at
rouhly ## times trailin earnins. .hat's more than % '@% times the multiple of a
competitor li5e >u5e Enery$ more than twice that of the SAB #&&$ and about on a par
with new1economy sex symbol Cisco Systems. Enron has an even hiher opinion of
itself. ?t a late16anuary meetin with analysts in 2ouston$ the company declared that it
should be valued at <'%D a share$ more than #&: above current levels. 3Enron has no
shame in tellin you what it's worth$3 says one portfolio manaer$ who describes such
atherins as 3revival meetins.3 Indeed$ First Call says that 'E of Enron's '8 analysts
rate the stoc5 a buy.
!ut for all the attention that's lavished on Enron$ the company remains larely
impenetrable to outsiders$ as even some of its admirers are =uic5 to admit. Start with a
pretty straihtforward =uestion; 2ow exactly does Enron ma5e its money? >etails are
hard to come by because Enron 5eeps many of the specifics confidential for what it terms
3competitive reasons.3 ?nd the numbers that Enron does present are often extremely
complicated. Even =uantitatively minded )all Streeters who scrutini7e the company for a
livin thin5 so. 3If you fiure it out$ let me 5now$3 lauhs credit analyst .odd Shipman at
SAB. 3>o you have a year?3 as5s +alph Bellecchia$ Fitch's credit analyst$ in response to
the same =uestion.
.o s5eptics$ the lac5 of clarity raises a red fla about Enron's pricey stoc5. Even owners
of the stoc5 aren't uniformly sanuine. 3I'm somewhat afraid of it$3 admits one portfolio
manaer. ?nd the inability to et behind the numbers combined with ever hiher
expectations for the company may increase the chance of a nasty surprise. 3Enron is an
earnins1at1ris5 story$'' says Chris )olfe$ the e=uity mar5et strateist at 6.B. Moran's
private ban5$ who despite his remar5 is an Enron fan. 3If it doesn't meet earnins$ Fthe
stoc5G could implode.3
)hat's clear is that Enron isn't the company it was a decade ao. In '99& around 8&: of
its revenues came from the reulated as1pipeline business. !ut Enron has been steadily
sellin off its old1economy iron and steel assets and expandin into new areas. In %&&&$
9#: of its revenues and more than 8&: of its operatin profits came from 3wholesale
enery operations and services.3 .his business$ which Enron pioneered$ is usually
described in vaue$ randiose terms li5e the 3financiali7ation of enery311but also$ more
simply$ as 3buyin and sellin as and electricity.3 In fact$ Enron's view is that it can
create a mar5et for Hust about anythinI as if to underscore that point$ the company
announced last year that it would bein tradin excess broadband capacity.
!ut describin what Enron does isn't easy$ because what it does is mind1numbinly
complex. CEO 6eff S5illin calls Enron a 3loistics company3 that ties toether supply
and demand for a iven commodity and fiures out the most cost1effective way to
transport that commodity to its destination. Enron also uses derivatives$ li5e swaps$
options$ and forwards$ to create contracts for third parties and to hede its exposure to
credit ris5s and other variables. If you thouht Enron was Hust an enery company$ have a
loo5 at its SEC filins. In its '999 annual report the company wrote that 3the use of
financial instruments by Enron's businesses may expose Enron to mar5et and credit ris5s
resultin from adverse chanes in commodity and e=uity prices$ interest rates$ and
forein exchane rates.3
?naly7in Enron can be deeply frustratin. 3It's very difficult for us on )all Street with
as little information as we have$3 says Fleischer$ who is a bi bull. -.he same is true for
Enron's competitors$ but 3wholesale operations3 are usually a smaller part of their
business$ and they trade at far lower multiples.0 3Enron is a bi blac5 box$3 ripes another
analyst. )ithout havin access to each and every one of Enron's contracts and its minute1
by1minute activities$ there isn't any way to independently answer critical =uestions about
the company. For instance$ many )all Streeters believe that the current volatility in as
and power mar5ets is boostin Enron's profits$ but there is no way to 5now for sure. 3.he
ability to develop a somewhat predictable model of this business for the future is mostly
an exercise in futility$3 wrote !ear Stearns analyst +obert )inters in a recent report.
.o some observers$ Enron resembles a )all Street firm. Indeed$ people commonly refer
to the company as 3the 4oldman Sachs of enery tradin.3 .hat's meant as a compliment.
!ut the fact that part of 4oldman's business is inherently ris5y and impenetrable to
outsiders is precisely the reason that 4oldman$ despite its powerful franchise$ trades at 'J
times trailin earnins11or less than one1third of Enron's B@E. ?nd as "on .erm Capital
tauht us$ the best1laid hedes$ even those desined by eniuses$ can o disastrously
wron. 3.ryin to et a ood rip on Enron's ris5 profile is challenin$3 says Shipman.
(or at the moment is Enron's profitability close to that of bro5eraes -which$ in fairness$
do tend to be more leveraed0. )hile )all Street firms routinely earn north of %&:
returns on their e=uity114oldman's +OE last year was %J:11Enron's rate for the '%
months ended in September -the last period for which balance sheet information is
available0 was 'E:. Even less appealin is Enron's return on invested capital -a measure
includin debt0$ which is around J:. .hat's about the same rate of return you et on far
less ris5y /.S. .reasuries.
Enron vehemently disarees with any characteri7ation of its business as blac5 box1li5e. It
also dismisses any comparison to a securities firm. 3)e are not a tradin company$3 CFO
?ndrew Fastow emphatically declares. In Enron's view$ its core business11where the
company says it ma5es most of its money11is deliverin a physical commodity$
somethin a 4oldman Sachs doesn't do. ?nd unli5e a tradin firm$ which thrives when
prices are oin wild$ Enron says that volatility has no effect on its profits11other than to
increase customers$ who floc5 to the company in turbulent times. !oth S5illin$ who
describes Enron's wholesale business as 3very simple to model$3 and Fastow note that the
rowth in Enron's profitability trac5s the rowth in its volumes almost perfectly. 3Beople
who raise =uestions are people who have not one throuh Four businessG in detail and
who want to throw roc5s at us$3 says S5illin. Indeed$ Enron dismisses criticism as
inorance or as sour rapes on the part of analysts who failed to win its investment1
ban5in business. .he company also blames short1sellers for tal5in down Enron. ?s for
the details about how it ma5es money$ Enron says that's proprietary information$ sort of
li5e Coca1Cola's secret formula. Fastow$ who points out that Enron has '$%'J tradin
3boo5s3 for different commodities$ says$ 3)e don't want anyone to 5now what's on those
boo5s. )e don't want to tell anyone where we're ma5in money.3
In addition to its commodities business$ Enron has another division called ?ssets and
Investments that is every bit as mysterious. .his business involves buildin power plants
around the world$ operatin them$ sellin off pieces of them$ 3investFinG in debt and
e=uity securities of enery and communications1related business$3 as Enron's filins note$
and other thins.
?ctually$ analysts don't seem to have a clue what's in ?ssets and Investments or$ more to
the point$ what sort of earnins it will enerate. Enron's results from that part of its
business tend to be =uite volatile11profits fell from <E%# million in the second =uarter of
'999 to <## million in the second =uarter of %&&&. In written reports$ Moran Stanley
chal5ed up the decline to the poor performance of Enron's 3sinificant number of
investments3 in telecom stoc5sI >ain +auscher )essels blamed it on a lac5 of asset sales.
In any event$ some analysts seem to li5e the fact that Enron has some discretion over the
results it reports in this area. In a footnote to its '999 financials$ Enron notes that it
boo5ed 3pretax ains from sales of merchant assets and investments totalin <J#D
million$ <D%8 million$ and <'ED million3 in '999$ '998$ and '99J. 3.his is an enormous
earnins vehicle$ which can often be called upon when and if mar5et conditions re=uire$3
notes /!S )arbur analyst +on !arone. (ot everyone is so chipper. 3)e are concerned
they are li=uidatin their asset base and boo5in it as recurrin revenue$ especially in
"atin ?merica$3 says analyst ?ndre Meade at Commer7ban511who has a hold ratin on
the stoc5. ?t the least$ these sorts of hard1to1predict earnins are usually assined a lower
multiple.
.here are other concerns; >espite the fact that Enron has been tal5in about reducin its
debt$ in the first nine months of %&&& its debt went up substantially. >urin this period$
Enron issued a net <E.9 billion in debt$ brinin its total debt up to a net <'E billion at the
end of September and its debt1to1capital ratio up to #&:$ vs. E9: at the end of '999. (or
does Enron ma5e life easy for those who measure the health of a business by its cash
flow from operations. In '999 its cash flow from operations fell from <'.D billion the
previous year to <'.% billion. In the first nine months of %&&&$ the company enerated Hust
<'&& million in cash. -In fact$ cash flow would have been neative if not for the <K'&
million in tax brea5s it received from employees' exercisin their options.0
!ut Enron says that extrapolatin from its financial statements is misleadin. .he fact
that Enron's cash flow this year was meaer$ at least when compared with earnins$ was
partly a result of its wholesale business. ?ccountin standards mandate that its assets and
liabilities from its wholesale business be 3mar5ed to mar5et311valued at their mar5et price
at a iven moment in time. Chanes in the valuation are reported in earnins. !ut these
earnins aren't necessarily cash at the instant they are recorded. S5illin says that Enron
can convert these contracts to cash anytime it chooses by 3securiti7in3 them$ or sellin
them off to a financial institution. Enron then receives a 3servicin fee$3 but S5illin says
that all the ris5s -for example$ chanes in the value of the assets and liabilities0 are then
transferred to the buyer. .hat's why$ he says$ Enron's cash flow will be up dramatically$
while debt will be 3way down$ way down3 when the company publishes its full year1end
results$ which are due out soon.
.hat's ood$ because Enron will need plenty of cash to fund its new$ hih1cost initiatives;
namely$ the hih1cost buildout of its broadband operations. In order to facilitate its plan to
trade excess bandwidth capacity$ Enron is constructin its own networ5. .his re=uires bi
capital expenditures. So broadband had better be a ood business. !oth Enron and some
of the analysts who cover it thin5 it already is. Included in the <'%D a share that Enron
says it's worth is <K& a share11or <E# billion11for broadband. Several of Enron's analysts
value broadband at <%# a share$ or rouhly <%% billion -and conratulate themselves for
bein conservative0. !ut <%% billion seems li5e a hih valuation for a business that
reported <K&8 million of revenues and <D& million of losses in %&&&. (ot all analysts are
so aressive. 3Laluin the broadband business is an 3extremely difficult$ uncertain
exercise at this point in time$3 notes !ear Stearns' )inters$ who thin5s that broadband$
while promisin$ is worth some <# a share today.
Of course everythin could o swimminly. Enron has told analysts that it plans to sell
between <% billion and <K billion of assets over the next '% months. .he bullish scenario
for Enron is that the proceeds from those sales will reduce debt$ and as earnins from
new businesses 5ic5 in$ the company's return on invested capital will shoot upward.
?lon with broadband$ Enron has ambitious plans to create bi businesses tradin a hue
number of other commodities$ from pulp and paper to data storae to advertisin time
and space. Berhaps most promisin is its Enron Enery Services business$ which manaes
all the enery needs of bi commercial and industrial companies. S5illin has told
analysts that its new businesses will enerate a return on invested capital of about %#:
over the lon run.
!ut all of these expectations are based on what )olfe$ the 6.B. Moran strateist$ calls 3a
little bit of the China syndrome311in other words$ if you et x: of y enormous mar5et$
you'll et 7 in revenues. For instance$ Enron says the lobal mar5et for broadband and
storae services will expand from <'## billion in %&&' to somewhere around <E8E billion
in %&&K. 3Even a modest mar5et share and thin marins provide excellent potential here$3
writes Ed .irello$ a >eutsche !an5 ?lex. !rown senior power strateist. .he problem$ as
we 5now from innumerable failed dot1coms$ is that the y enormous mar5et doesn't
always materiali7e on schedule. ?nd Enron isn't leavin itself a lot of room for the
normal wobbles and litches that happen in any developin business.
In the end$ it boils down to a =uestion of faith. 3Enron is no blac5 box$3 says 4oldman's
Fleischer. 3.hat's li5e callin Michael 6ordan a blac5 box Hust because you don't 5now
what he's oin to score every =uarter.3 .hen aain$ 6ordan never had to promise to hit a
certain number of shots in order to please investors