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With Growth Slowing, Enron's Fall Is Far From Over
By Peter Eavis
Senior Columnist
Originally posted at 7:25 PM ET 7/12/01 on RealMoney.com
It's now clear why Enron's (ENE:NYSE - news - commentary) stock has
plunged more than 40% this year.
The energy-trading behemoth reported
second-quarter results Thursday that
betrayed several signs that its once red-hot
business is slowing. Houston-based Enron
also set mildly bullish 2002 earnings guidance
Thursday of $2.15 a share, 2 cents above
analysts' estimates. Recent developments,
however, suggest this target will be hard to
meet and that the stock should fall further.
Enron made 45 cents a share in the second quarter, 3 cents more than Wall
Street expected. It also confirmed its 2001 earnings guidance of $1.80. The
stock rose 0.9% to $49.55 Thursday.
Gotta Get Broadband
At first glance, the most shocking part of second-quarter earnings was the
$102 million operating loss from Enron's broadband operations; for the
previous four quarters, the average operating loss there was just $24 million.
Launched just over a year ago to great applause from Enron's ardent sell-side
analysts, this business is now in intensive care. Enron CEO Jeff Skilling,
whose recent heavy sales of company stock make him one of the biggest
Enron bears in the market, didn't attempt to sugarcoat the result. "There's a
meltdown out there," he said on a Thursday conference call in reference to the
broadband business.
While the broadband loss was blatant and ugly, other less obvious trends
gave cause for concern.
Wholesale Slowdown
For example, key revenue numbers slowed. The wholesale services division,
the trading and investment unit that accounts for 97% of Enron revenue,
reported a slight sequential quarterly decline in its top line, compared with
sequential gains of between 20% and 75% in the previous four quarters.
Wholesale service second-quarter revenue of
$48.48 billion was essentially flat with the
previous quarter's $48.51 billion. It was up
204% up from the year-ago level, reflecting
the explosion in energy volumes and volatility
over the past 18 months. But this rise was
well below the near-300% year-on-year
increases posted in the previous two quarters.
How about profits? Wholesale reported
second-quarter operating earnings of $802 million, up 6% from the previous
quarter and 93% above the year-ago figure. Operating earnings in the
commodity sales and services line, the largest part of wholesale, fell 3%
sequentially to $762 million, though they rose 81% from a year ago.
Wholesale benefited from a sizable increase in earnings from the so-called
assets and investments line, the other business in the segment.
Earnings from assets and investments are considered to be of lower quality
than those from the commodity sales line because a good chunk of the
returns depends on profitability assumptions made by Enron itself. Assets
and investments brought in $134 million in operating earnings, up well over
100% from the immediately previous and year-ago periods.
Changing Times
On the call, Enron investor relations executive Mark Koenig said about a third
of the assets and investment earnings came from recurring income that Enron
receives from operations in which it invests. However, a good part of it came
from valuation adjustments to its portfolio of merchant investments. Koenig
said Enron had "better valuations" in the portfolio compared with the year-ago
quarter.
Now, it's just about possible that portfolio valuations have risen over a
12-month period. But it's really hard to see how valuations can have increased
so much from the first to the second quarter, as implied by the big jump in
asset and investments income. Remember that in the first quarter, earnings
from assets and investments tanked. Enron's quarterly financial filing with the
Securities and Exchange Commission said that the decline was "a result
of a decrease in the value of Wholesale Service's merchant investments."
What radically changed in the second quarter to reverse first-quarter
softness?
Enron provides enough disclosure of expenses to do close-up margin analysis
of some of its business lines. Maddeningly, however, it doesn't break out
costs for the two businesses included in the massively important wholesale
segment: commodity sales and services, plus assets and investments.
The overall operating margin on wholesale was 1.65% in the second quarter,
up from 1.56% in the previous quarter. Fine, but was the margin improvement
from the easy-to-tinker assets and investments line, or commodity sales?
Enron doesn't make it possible to tell.
Margin Squeeze?
Skilling also noted that Federal Energy Regulatory Commission plans to
set up four regional electricity transmission organizations would be a big plus
for Enron. These regional transmission organizations, or RTOs, "will benefit
the type of business that Enron does," Skilling said.
However, while the RTOs may boost Enron volumes, they could also bring
greater efficiency and therefore reduced trading margins. Investors may argue
how long it will take for these efficiencies to hurt Enron's profits, but one thing
is clear: Wholesale's operating margins are already under pressure, falling
from 2.6% a year ago to 1.65% now.
The subject of Enron's related-party transactions came up on the call. These
have sparked much chatter because it's not clear how much Enron's earnings
have been aided by deals done by these entities. When an analyst asked
Thursday about impact in the second quarter from an entity called LJM
Capital Management, whose general partner is Enron's chief finance officer,
Andrew Fastow, Skilling said LJM had done "a couple of real minor things."
Again, little else was disclosed.
Enron now trades at 23 times its expected 2002 earnings. Because it's little
more than an energy-focused investment bank, it should have a
price-to-earnings ratio of no more than 17. Using that multiple on expected
2002 profits would take the stock down to $37. But since this column
considers $2.15 to be ambitious, and since disclosure is poor, Enron should
trade at 15 times $2, which is $30. Oh yes, that's 40% further that Enron has
to fall. |
