Corporate Case Study on Enron
Executives at high-flying Enron Corp. (ENE ) never seemed overly concerned with how the rest of the world viewed their business practices. Earlier this year, the California Attorney General had to get a court order to collect documents in an industry wide investigation into energy price fixing. And when an analyst challenged former CEO Jeffrey K. Skilling in a conference call to produce Enron's balance sheet, Skilling called him an "ass----." Still, even some Enron executives worried that the company had gone too far with two complex partnerships set up in 1999 to buy company assets and hedge investments. With Enron's then-chief financial officer acting as general manager of the partnerships and in a position to personally benefit from their investments, the potential for a conflict of interest and backlash from investors seemed overwhelming. "Internally, everybody said this is not a good idea," says a source close to the company. But no one could have predicted such a jaw-dropping outcome for the nation's largest and most innovative energy trader. Since Oct. 16, when Enron revealed a $35 million charge to earnings to reflect losses on those partnerships and was forced to knock $1.2 billion off its shareholders' equity, the company's stock has plunged 60%.
The Securities & Exchange Commission is investigating Enron's accounting for its partnerships and whether it properly disclosed them to investors. Suddenly the company, which brought high-tech and complex finance to energy trading, is essentially trying to avoid a run on the bank. Moody's Investors Service has already downgraded the company's debt. Enron says it is meeting with credit agencies to calm their fears, and analysts say Enron is working on a turnaround plan that would likely include accelerating asset sales, issuing shares, and obtaining new credit lines. Enron's board has set up a special committee to look into its controversial partnerships. But analysts also worry that Enron's trading partners could pull the plug if they lose confidence that it can honor its trades. "ON CRACK?"
Inside Enron, once-cocky employees are reeling. They were still puzzling over the abrupt Aug. 14 departure of CEO Skilling when the company announced on Oct. 24 that CFO Andrew S. Fastow, architect of the controversial private LJM investments--which got their name from the first initials of his wife and children--was removed from his post and on leave. In a tense meeting held at a Houston hotel after the latest financial disclosures, soft-spoken Chairman and CEO Kenneth L. Lay faced 1,600 employees, with another 5,000 hooked up via the Web. One irate worker asked if he was "on crack." Lay, an economist by training, turned over day-to-day management in 1997. Until Skilling quit, citing personal reasons unrelated to Enron, Lay was talking about retirement, sources say.
Now he is facing his biggest fight ever. "Ken is looking at a 30-year career of accomplishment going down in flames. This is just awful," says one friend. On the surface, at least, Enron's off-balance-sheet maneuvering hardly seems the stuff that would crater a company. Amazingly, sources close to Enron claim that one rationale for Fastow's deals was to save an estimated $30 million a year in investment-banking fees. Fastow's involvement in the partnerships, which bought assets from Enron, including stakes in telecom and energy, was supposed to make the deals simpler for the investment bankers and thus cheaper. They were also meant, according to sources close to the company, to hedge Enron's investments in potentially risky assets while allowing it to maintain some control over them. Enron says Fastow made money for himself on some of the deals, but insiders insist there were less controversial ways to enrich him if that were the aim.
Fastow did not return calls seeking comment. Lay, who declined to comment for this story, has said that the partnerships were properly vetted by Enron's attorneys and internal and external auditors and were approved by its board. A source familiar with Enron agrees: "We had the best lawyers in the world saying, `It looks fine."' But whatever Enron's reasons for creating the LJM partnerships, the problems were compounded by scanty disclosure. The deals were first revealed in a 1999 proxy, raising concerns from investors and analysts. By this summer, when Enron's stock was falling and its bets in broadband were souring, complaints about LJM grew louder. So in June, Fastow pulled out of the partnerships. When the write-offs came, Enron enraged analysts and investors further by failing to disclose the hit to equity in its third-quarter earnings press release. Instead, Lay mentioned it in a conference call with analysts. "We found it disconcerting that the company waited to disclose the additional $1.2 billion charge to equity in a fleeting comment in the middle of its conference call," says UBS Warburg analyst Ronald Barone. BAD BETS. Still, Enron's credibility did not vanish overnight.
Analysts have been lobbying for years for more information about how and where Enron makes its money in its often byzantine trading business. While the company's revenues were soaring from $9.2 billion in 1995 to $100.8 billion in 2000 and its stock was returning 500% during the same six-year period, Enron's aggressive, even arrogant managers could ignore Wall Street's complaints with impunity. But after its stock price collapsed this year (chart), the company's attitude and operational missteps quickly caught up. And there was plenty to worry about. The company's $3 billion power plant in India wasn't paying its bills amid a political controversy; its highly ballyhooed business for trading high-speed communications capacity was crippled by the telecom industry meltdown; and its calamitous foray into the water business with Azurix Corp. has already cost Enron at least $574 million in write-offs. These bad bets and the expensive LJM shock have investors worried about what else might be lurking at Enron.
Many aren't sticking around to find out. "I think the lack of disclosure on their financial engineering killed the credibility of the management team," says Richard A. Giesen, who manages the Munder Power Plus fund, which dumped its Enron shares about a month ago. It's not clear just how many off-balance-sheet financing vehicles Enron has used over time. Some were created years ago to finance oil and gas producers. Analysts and sources close to the deals say there's no particular risk in these to Enron shareholders. Other interconnected entities, such as Whitewing, Osprey, Atlantic Water Trust, and Marlin Water Trust, were a way to get assets no longer central to Enron's strategy off its balance sheet, freeing capital and credit for the core energy business and ventures like broadband (table).
To entice institutional investors such as pension funds and insurers into these deals, Enron promised to kick in equity if asset sales weren't enough to cover debt. Such "mandatory equity" deals have been used by at least a half-dozen others in the energy and telecom industries, including El Paso (EPG ), Williams, and Dominion (D ), says Standard & Poor's director Todd A. Shipman. "Nobody's going to find anything that's particularly unique or below board" in such deals, says one investment banker specializing in the energy business. Worst case, which Shipman considers unlikely, Enron could be on the hook for about $3 billion in its mandatory-equity deals. That could mean diluting its shares by more than 25% at today's prices. Analyst John E. Olson at Sanders Morris Harris Inc. (SMHG ) figures a 9% dilution is more likely. Even if this $3 billion in debt were included on Enron's balance sheet now, the debt-to-capital ratio would climb to 54% from about 49% at the end of June. Such a change would pressure Enron's credit rating but not push it below investment grade, says Shipman. HUGE HIT.
Fastow's LJM, a private equity fund, was a different kind of animal, according to sources familiar with the arrangements. It bought energy and other assets from Enron, which booked gains and losses on those deals. LJM was also involved in complex hedging that was supposed to reduce the volatility of some of Enron's investments, including stakes in high-tech and telecom businesses and an interest in New Power Co., which markets power to consumers. When Enron terminated these deals in September, it took the $1.2 billion hit to equity. But the more immediate question is whether trading partners will stick with the company. The first place that might show up is in Enron's highly successful online platform, which trades everything from gas and electricity to weather derivatives. To reassure its partners, Enron is scrambling to shore up its liquidity.
It has already tapped $3 billion in credit lines and is trying to arrange another $1 billion. Shipman says he has seen no signs of massive customer defections or drastically worsened credit terms. Still, rival traders are wary. "We certainly have taken a closer look at Enron in the last week to 10 days and will continue to manage the credit risk, but we're still doing business with the company as usual," says Keith G. Stamm, CEO of power and gas trader Aquila Inc. (ILA ) "SPEEDING TRAIN." Still, with the stock battered and rating agencies considering further downgrades, that could rapidly change. In recent days, the uncertainty about Enron's future has reduced investors' appetite for Enron debt. "No one wants to speculate on the direction or their likelihood of survival," says a credit-derivatives salesperson. "It's really difficult to get in front of a speeding train." Even if Lay can calm his trading partners, he and his management team face a much tougher task of restoring their credibility on Wall Street.
With the stock now hovering around $14--down from a high of $90 in August, 2000--some even believe that Enron could be a takeover target for the likes of GE Capital or Royal Dutch/Shell Group. (RD ) Both declined to comment. Would Enron sell? One source close to the company says Enron has talked about possible mergers and strategic alliances in the past with Royal Dutch/Shell, among others. "If they're really worried about liquidity, they might take the easy way out," he says. If Enron does pull through this crisis, some suspect it will be a humbler, more risk-averse place. The company that once believed it could expand its trading and logistics empire to all manner of commodities--from advertising space to steel--will be forced to scale back its grandiose visions. That's something some investors applaud. "The company should focus on its strengths," says William N. Adams, senior energy analyst at Banc of America Capital Management, a major shareholder. But that's a far less exciting place than Enron's energy cowboys ever hoped to roam.
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