WASHINGTON, Nov. 26 (UPI) -- In the light of Enron Corp.'s difficulties, which last week brought into question its survival without a trip through Chapter 11 bankruptcy, I thought it worthwhile to examine corporate failure in general and Enron's case in particular to see what are the possible danger signals.
Enron's near collapse to date is remarkable because of its speed. In January, then Chief Executive Officer Jeffrey Skilling was predicting an Enron stock price of $80, about 50 percent above where it was then trading. Then at the International Swap and Derivatives Association annual conference in April, he was still claiming that Enron had revolutionized the energy business by moving it to a trading platform and thereby removing layer upon layer of overhead costs.
By June, Skilling was history, as far as Enron was concerned. In September, Enron announced a $1 billion writedown and only two weeks ago Enron announced a plan to merge with its much smaller competitor, Dynergy Inc. By the end of last week, it was looking doubtful whether Dynergy would complete the transaction after Enron's stock price slumped below half the merger value and a tranche of $690 million of Enron's debt was renegotiated on an emergency basis. Enron teeters on bankruptcy in a recession that is still being called "among the mildest on record," by Economy.com.
There appears to be three keys to Enron's downfall: its business and growth; its accounting; and its management reward system.
Enron's original business, namely gas pipelines, was more or less idiot-proof once the things had been built and provided the debt load of the business remained under control. Tariffs were regulated until 1983 and even after that there were a limited number of obvious potential customers for any particular pipeline, so product sale negotiations were not particularly difficult.
The trouble began when Enron diversified in two directions.
First, it moved toward ownership of energy assets in overseas markets, including the notorious Indian Dabhol gas-fired electric power project. Enron's Indian venture was remarkable only because it seems never for one moment to have looked like becoming a success.
It is now pretty clear that Enron was, to a large degree, clueless in its international operations, which it is now attempting to sell off at a heavy discount to book value or acquisition cost. I'm not sure why anybody should have expected them to be other than clueless; operating a regulated business, which is entirely domestic (OK, with occasional stretches to Canada or possibly Mexico) requires a far narrower set of skills than constructing vital elements of national infrastructure in the Third World. Other naïve U.S. companies that have invested in the even more arcane market of China still may be under the impression that their projects are satisfactory and only prolonged recession will sort them out.
The other business that Enron entered, more or less simultaneously, was that of trading: first in natural gas, then in other forms of energy, and finally in the mysterious and tangible "bandwidth." This (maybe excluding the bandwidth) was at least a natural extension of Enron's primary business. After natural gas deregulation, some kind of trading operation was more or less necessary as an adjunct to Enron's transportation capacity, so it made sense to use the trading itself, which appeared profitable, as the basis for Enron becoming a new and very much more exciting business.
Trading, as has been discovered over and over again on Wall Street, is a business that relies heavily on superb control systems. Traders act according to their market knowledge, short-term market moves and sheer instinct. And if allowed to, they will trade in ways, which maximize their own remuneration while not necessarily benefiting the firm they trade for.
Indeed, one particular trading strategy, the Martingale, allows traders to create a high probability of a satisfactory trading year, producing a good bonus, at the cost of a small probability of bankrupting their employer (which of course, from their point of view, if fraud is not involved produces no loss beyond that of their job.) Thus a large trading operation has an inherent instability and is extremely opaque to outside observers. It is essentially impossible to discover its true profitability if traders or their management wish to hide it.
This is where Enron's accounting policies come in. Using derivatives and differentiating between "long-term" and "short-term" positions, a trading operation can make profits come out any way it wants, hiding losses in a "back book" of trades that are rolled over ad infinitum if required. Of course, doing this distorts the picture both for outside investors and, if it is done in management accounts, for management itself.
Investors in a trading operation need to have confidence that this is not being done, otherwise the true profitability of the trading operation may be wildly distorted. In addition, any company dealing heavily in off-balance sheet items such as futures and derivatives has the potential to hide indebtedness, making its leverage look less than it really is. As was disclosed in September, both these mistakes were made at Enron.
The purpose of accounting, it is to be remembered, is to present a company's operations to its outside investors. The auditors are employed by the stockholders, not by management.
Enron's operations suffered from a third problem, endemic in the 1990's, and the excessive remuneration of management. Of course, some companies, like Cisco, remunerated management excessively (by $8 billion worth of stock options in the year to July 2000) and have lived (so far) to tell the tale. In Enron's case, the stock-option scheme, while smaller than Cisco's, was itself excessive, even given the rapid growth of the company, with the shareholder wealth lost through options exercised in 2000 being $1.47 billion, or 150 percent of alleged net income (before later write-downs) for that year. And Enron's chief financial officer was permitted to form hedging vehicles that entered into derivatives contracts with Enron, thus achieving an undisclosed further level of remuneration. This violates the most basic principles of fiduciary responsibility between a company's management and its shareholders.
The future for Enron is uncertain, although the company's share price, down another 15 percent to $4.01 Monday after its heavy falls last week, appears to be discounting the worst. The company's core activities in natural gas transmission have value, and its trading operations ought to have value if only because Enron has a leading market share in a number of trading areas. But it is by no means clear how profitable Enron's trading operations actually were, nor what are the true liabilities from "off balance sheet" contracts of one sort or another.
Enron's acquirer, Dynergy, knows the business well and itself is a substantial trader, and is part owned by ChevronTexaco, which presumably has pockets deep enough to solve even Enron's problems. But Enron's debts mature soon, their debt rating has been downgraded to "junk" status (thus making it very difficult for its traders to operate) and the accounting and management uncertainties in Enron are huge, and difficult to unravel in a short time frame.
It's a close one.
There are a number of lessons which investors can learn from the Enron saga, and from similar sagas both recently and in past downturns.
First, beware funny accounting. If you (or your financial advisor) don't understand every item on a balance sheet, even after reading the SEC 10-K filing, avoid the company. There may be a perfectly innocent explanation, but the chances are the company doesn't want you -- as an investor -- to know something. If that is the case, and the undisclosed item becomes a problem, then market confidence in the company can instantly disappear, and the company is then at the mercy of its creditors.
Second, trading operations are inherently unstable and difficult to control.
The other examples here that come to mind are financial.
One is Slater Walker, in the UK, which in 1972 was the largest merchant bank in Europe but ended in bankruptcy and the imprisonment of some of its directors. Slater's problem was partly trading, and partly private equity investments; in both cases its financial statements were singularly obscure.
The second example is Drexel, the most profitable investment bank in the U.S. in 1987, bankrupt early in 1990. Again, there were no controls over Mike Milken's trading empire, even though in retrospect Milken's operation contributed considerably to U.S. economic regeneration in the 1980's and 1990's.
Third, beware debt. High tech companies, if conservatively managed, are less dangerous in this respect than companies such as Enron (or indeed Slater or Drexel) that have access to leverage. A Polaroid or a Xerox can stagger on for decades after its technology has ceased to be unique or even, in Polaroid's case, relevant, with bankruptcy coming only when the company has gone through several economic cycles of descent and has exhausted the cash reserves built up during the good years. In this respect, a Cisco, even if its share price never again reaches a fifth of its highs, may well outlast many of its staider rivals because of its cash. Note, however in Cisco's case that the company is aggressively managed and has historically had an appetite for private equity investments, in a downturn notorious cash sinks. I would thus be more confident over the next decade in say Microsoft, which however vulnerable to technological obsolescence is at least not likely to run out of cash anytime soon.
An Enron, on the other hand, faces debt repayments every month. If its business is long term, like the original gas pipeline, this is not too worrying because banks will live with even quite a prolonged downturn in a transparent and basically sound business. For a short-term trading business or a technology business (think the telecom companies), bank credit lines may be very much less available when times are hard, and the business may descend into the arms of its creditors with remarkable speed, as Enron has shown.
In this recession, which is extremely unlikely to be "one of the mildest on record" investors need to be sure that the companies they invest in will still be there when growth resumes. Choose solid businesses that are easy to understand, and which have management that has shown an ability to focus. Limit the exposure to technology and make sure technology investments are leaders in at least a substantial (and comprehensible) product area. Avoid companies that appear to have a lot of debt, or that have oriented themselves heavily towards trading operations. And, above all, avoid companies whose financial disclosure is incomprehensible or in which the accounting standards chosen appear to be aggressive.
The two latter categories include that icon of the 90's, General Electric. Yes, even avoid GE!
(The Bear's Lair is a weekly column which is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the last 10 years, the proportion of "sell" recommendations put out by Wall Street houses has declined from 9 percent of all research reports to 1 percent. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
