ENE--Combination of Brilliance, Overconfidence Helped Enron Fly High and Plummet Fast
By REBECCA SMITH and JOHN R. EMSHWILLER
Staff Reporters of THE WALL STREET JOURNAL
November 8, 2001
When Enron Corp. convened its annual conference with credit analysts and bond investors in Houston last February, the energy-trading giant was soaring and looking to climb higher.
The company's stock was trading at about $80 a share, giving it a stock market value of $70 billion. Though up fourfold from three years earlier, the stock price wasn't nearly high enough, Enron's new chief executive, Jeffrey Skilling, told the audience. With its dominant position in energy-trading markets and its highly touted new moves into telecommunications, Enron stock should be at $126 a share, Mr. Skilling argued.
All in all, a vintage performance for a company not known for being bashful. "A lot of hype. A lot of spin," recalls Todd Shipman, a Standard & Poor's analyst who attended the conference. "That was Enron."
Wednesday, Enron stock closed at $9.05 in New York Stock Exchange trading. Mr. Skilling is no longer around to promote the stock. In August, he unexpectedly resigned as chief executive after only six months in the top job. Chief financial officer Andrew Fastow was replaced last month as controversy escalated over his role in running private partnerships involved in billions of dollars of transactions with Enron. Kenneth Lay, Enron's chief executive, has had to give up retirement plans to return to the helm.
Over the last few days, the company has been offering special credit protection to increasingly nervous trading partners, including Reliant Energy Inc. and Apache Corp. The effort was aimed at providing assurance that Enron is a creditworthy partner and to prevent an exodus of customers. Enron's trading operation generates 90% of the company's profits.
It looked Wednesday as if the endgame might be beginning. Mr. Lay and Enron's board were discussing a possible acquisition of Enron by its much-smaller hometown energy-trading rival, Dynegy Inc., in a stock swap valued at $7 billion to $8 billion.
Any merger of the two companies would probably face lengthy regulatory scrutiny, so Dynegy is also considering injecting $1.5 billion into Enron immediately to help stabilize the company's finances, according to people familiar with the situation. The deal would also include a significant role for oil powerhouse ChevronTexaco, which owns a 26% stake in Dynegy and would be likely to provide much of the cash for any Enron transaction.
Dynegy's emergence as a serious bidder for Enron could indicate to other interested parties that Enron's problems can be solved. In fact, the collapse in Enron's stock price would make it fairly easy for another large energy player to top any Dynegy offer. Royal Dutch/Shell Group is one such prominent company. Enron has approached General Electric Co.'s GE Capital unit as a potential investor.
A takeover by Dynegy or any other company would almost certainly presage the departure of the 59-year-old Mr. Lay. He oversaw the transformation of Enron from a nondescript natural-gas pipeline company with annual revenue of under $5 billion in the late 1980s to a global energy colossus with revenue that is expected to approach $200 billion this year.
It has turned out that the formula behind that transformation contained the seeds for its current troubles. Executives created an ever-more-labyrinthine financial structure to support Enron's explosive growth rate. Billions of dollars of debt -- which could have weakened Enron's credit rating and slowed growth -- was kept off the balance sheet through tangled webs of transactions with dozens of related entities. As the financial demands became greater and the transactions more complex, Enron officials began creating and heading some of the entities, raising serious conflict-of-interest questions.
Neither Enron nor Dynegy would comment. Royal Dutch/Shell and GE also declined to comment. Messrs. Lay, Skilling and Fastow didn't return phone calls seeking interviews.
Enron officials have maintained that the markets are overreacting to a spate of bad, but nonfatal, news. On Oct. 16, the company announced a $618 million third-quarter loss and disclosed a $1.2 billion reduction of shareholder equity due in part to dealings with the Fastow-related partnerships. The company has said that its ongoing businesses are strong and it has the financial wherewithal to weather the crisis. All of its actions have been legal and properly disclosed, Enron has stressed.
Still, its predicament is daunting. The Securities and Exchange Commission has started a formal investigation into possible violations of federal securities law involving the Fastow-related partnerships. Several shareholder lawsuits seeking class-action status have been filed against top company officials, alleging fraud and seeking to recover some of the $20 billion in market value that Enron shares have lost in the past month. To address growing jitters in the energy and financial markets, Enron has drawn down billions of dollars of credit lines, negotiated new ones and sought a new equity infusion.
As turmoil has engulfed the company, Mr. Lay and other top Enron executives have kept largely out of public view -- in sharp contrast to the company's normally outspoken public persona. The one recent public-relations initiative, a conference call for analysts and big investors, turned into what even Enron officials concede privately was a debacle. It left company executives looking evasive and defensive rather than open and confident.
How did Enron, which routinely made published lists of the most-admired and innovative companies in America, fly so high and fall so fast? The answer lies in a combination of brilliance and overconfidence on a scale rarely seen in the business world.
In the process, the company helped redefine much of the energy marketplace on matters as fundamental as how power is bought or sold and how a company produces a profit from doing so. For example, the company helped create an electricity-trading market in which the participants rarely take physical delivery of the commodity but instead merely tally profits or losses from transactions.
In the accounting realm, it pioneered techniques that allowed energy companies to record profits or losses on long-term contracts that hadn't yet produced any revenue. "We caught a little flak in the early 1990s from people who I guess thought we were pulling a fast one," Enron's chief accounting officer, Richard Causey, said in an interview in August. He added that this accounting method was the most accurate way to measure energy-trading results.
Enron's audacity and success sent other energy companies scrambling to emulate it, a process that ABN Amro analyst Paul Patterson calls "Enron envy."
The company tested the limits of securities and accounting rules. For example, Enron's SEC filings have included statements about the Fastow-related transactions that might meet the letter of disclosure laws but are so complex that even some Wall Street analysts and accounting professors have found them indecipherable.
Enron's seemingly impenetrable financial structure, hardly noticed by Wall Street in the company's heyday, is now a matter of serious concern in a suddenly skeptical investment community. "It's not easy to regain something as basic as trust," says Goldman Sachs analyst David Fleischer, a longtime Enron fan. In the recent conference call with Enron executives, Mr. Fleischer pleaded with the company to be more forthcoming about its operations -- something it has been promising to do for months.
While Enron employs some 20,000 people, its rise and fall can, in large measure, be traced to three men: Messrs. Lay, Skilling and Fastow. <bMr. Lay joined the company in 1984 when it was still called Houston Natural Gas, a regional pipeline operator. Back then, the natural-gas industry was a largely regional business and about as exciting as watching a pipeline operate.
But Mr. Lay had big plans for his company, always preaching that natural gas was the fuel of the future. His prediction has been largely borne out when it comes to such functions as fueling electric-power plants.
He wanted to take the company beyond natural gas into other areas. Enron bought an electric utility in Portland, Ore., and built power plants around the world. It developed a potent energy-trading operation, which bought and sold contracts to provide electricity in the same way that contracts for wheat and pork bellies are traded. These deals were done with utilities, industrial power users and other trading firms.
To help enlarge this empire, he recruited aggressive young executives. None was brighter or more assertive than Mr. Skilling, a Harvard Business School graduate and former McKinsey & Co. consultant who joined Enron in 1990.
Under Messrs. Lay and Skilling, the company pushed zealously for the deregulation of energy markets -- particularly that bastion of monopoly businesses, the electric-utility industry. Enron officials argued that open, competitive markets could help consumers and, not coincidentally, provide huge profit opportunities in energy trading.
Mr. Skilling called the energy-trading business "a once-in-a-lifetime opportunity to establish a position to last for the next 100 years." By the late 1990s, Enron had evolved into primarily a trading company, rather than an owner of power plants and pipelines.
In pursuit of their deregulation goals, Enron officials became major players in American politics. Mr. Lay has given some $2 million to President Bush during his political career and is a personal friend of the president, Vice President Cheney and several members of the cabinet.
One of Mr. Skilling's early hires after joining Enron was Mr. Fastow, at the time a 29-year-old MBA from Northwestern's Kellogg School who had been working on leveraged buyouts and other complicated deals at Continental Illinois Bank in Chicago. Former Enron officials and others say that Mr. Skilling quickly became Mr. Fastow's mentor in the same way that Mr. Lay had become Mr. Skilling's.
As Mr. Skilling oversaw the building of Enron's vast trading operation, Mr. Fastow saw to the financing of it. "Andy was the guy you saw when you wanted money" for a project, says one former Enron senior manager.
Mr. Skilling was named Enron's chief operating officer in 1997. Mr. Fastow got the top finance job a year later, at the age of 36. Under Mr. Fastow, Enron's finance department tripled in size, to more than 100 people.
Enron needed the added financial brainpower. As it expanded, debt and liquidity were constant concerns. What's more, the company's ambitions were roving beyond therms and kilowatts as it began to make markets in everything from water to weather.
Enron's most highly touted non-energy intiative, and Mr. Skilling's pet project, came in the area of broadband telecommunications. The company built a coast-to-coast fiber-optic network and envisioned trading "bandwith," or network capacity, the way it traded electricity or natural gas. Enron has invested several hundred million dollars so far in the project, which has produced losses of over $400 million. Yet at the February analyst meeting in Houston, Mr. Skilling unabashedly valued Enron's fiber-optic business at $36 billion, according to people who were at the meeting.
But to make all of its growth dreams possible, Enron had to make sure that its balance sheet didn't become too laden with debt. Too much debt would lead major ratings agencies, such as Moody's and Standard & Poor's, to lower Enron's credit rating. Such downgrades could significantly increase the company's cost of borrowing and make it more difficult to finance its continued expansion.
In typically aggressive fashion, Enron lobbied the ratings agencies with the same vigor that it lobbied legislators. At the February meeting, Mr. Fastow urged analysts to raise Enron's credit rating on long-term debt from triple-B-plus to single-A-minus. But the analysts shrugged off Mr. Fastow's entreaties. They didn't see the cash flow, earnings, or debt coverage required for such an upgrade, says one attendee.
Undeterred, Mr. Fastow said the higher rating would strengthen the company's basic finances, which could then justify the higher rating. This circular argument provoked derision among analysts, and Enron didn't get its 'A' rating. Instead, the company was recently downgraded by the major ratings agencies as a result of its financial turmoil.
In moves that kept down its reported debt burden, Enron turned increasingly to off-balance-sheet transactions through limited partnerships with outside parties. In such an arrangement, Enron could contribute money, stock or other assets to the partnership. The partnership could then borrow large sums to purchase assets or do business deals without the debt showing up on Enron's books.
While such partnership transactions had long been used in the natural-gas industry to finance deals, Enron took the practice to new heights of complexity and sophistication. Leading that effort was Mr. Fastow and his team of young financial experts.
In recent years, Enron has done myriad deals with more than 30 partnerships. By far the most controversial to come to light, so far, are the ones it has done with two partnerships -- known as LJM Cayman LP and LJM2 Co-Investment LP -- which were formed and operated by Mr. Fastow. The company says that its transactions with these partnerships were designed to hedge against fluctuating market values of company assets and energy contracts.
It isn't clear why Enron would allow its chief financial officer to be in a fiduciary position at partnerships that stood to profit, possibly at the company's expense, from doing deals with it. To make matters worse, private LJM partnership documents indicate that Mr. Fastow personally made millions of dollars from the partnerships -- much more than he was being paid as Enron's chief financial officer.
Enron officials have repeatedly said that Mr. Fastow's actions were reviewed and approved by top management and the board of directors. However, the company has refused to answer numerous specific questions about its dealings with the partnerships. Enron has said that Mr. Fastow formally severed his ties with the partnerships in July in the face of rising discomfort about the arrangements on the part of analysts and major company investors.
It is nearly impossible to stitch together anything comprehensible about the partnership deals from Enron's SEC filings. The only thing clear is that millions of shares of Enron stock and billions of dollars of assets and notes were involved in the transactions.
--------------------------------------------------------------------------------
Enron's Odyssey
Oct. 16: Enron takes $1.01 billion charge related to write-downs of investments. Of this, $35 million is attributed to partnerships until recently run by CFO Andrew Fastow. Enron also discloses it shrank shareholder equity by $1.2 billion, as a result of several transactions including ones undertaken with Fastow's investment vehicle.
Oct. 17: SEC sends letter to Enron saying it was beginning an "informal inquiry."
Oct. 19: The Wall Street Journal discloses that general partners of Fastow partnership realized more than $7 million last year in management fees and about $4 million in capital increases on an investment of nearly $3 million in the partnership, set up principally to do business with Enron, according to internal partnership document. Enron's board meets to discuss SEC inquiry.
Oct. 22: Enron announces SEC will begin a probe of company's "related party transactions," including those with Fastow partnerships. Enron says it will fully cooperate.
Oct. 23: Enron's treasurer acknowledges the company may have to issue additional shares to cover potential shortfalls in investment vehicles it created, although he says the company believes it can repay about $3.3 billion in notes that were sold by those investment vehicles without having to resort to issuing more stock.
Oct. 24: Enron replaces Fastow as CFO with Jeffrey McMahon, the 40-year-old head of the company's industrial-markets division. Enron shares fall 17% on heavy volume ahead of the announcement.
Oct. 25: The company draws down about $3 billion, the bulk of its available bank credit lines, in a bid to restore confidence in its financial strength and liquidity. The Fitch rating agency puts Enron on review for a possible downgrade, while another, Standard & Poor's, changes Enron's credit outlook to negative from stable. A noninvestment-grade rating would throw the company into default on obligations involving billions of dollars of borrowings.
Oct. 29: Moody's lowers its ratings by one notch on the Enron's senior unsecured debt and kept the company under review for a possible further downgrade. Shares fall below $14 on the NYSE.
Oct. 31: The SEC elevates to a formal investigation its inquiry into Enron's financial dealings with partnerships headed by Andrew Fastow. Enron shares rise $2.74 to $13.90, after plunging for 10 straight days.
Nov. 1: Enron says it has secured commitments for $1 billion in financing from units of J.P. Morgan and Citigroup, as the company moves to strengthen its balance sheet and maintain its investment-grade credit rating.
Nov. 4: An Enron deal is raising new questions about financial dealings with management. A $35 million purchase from an entity run by a company officer appears to be just one transaction that let Enron keep millions in debt off its balance sheet for three years.
Nov. 5: Enron has held talks with private-equity firms and power-trading companies for a capital infusion of at least $2 billion as it faces an escalating fiscal crisis. |
