Enron the Incredible
Forbes | 01/15/2002 | Dan Ackman
NEW YORK - Most of the attention paid to Enron's finances has focused on its balance sheet--in particular how it hid debt by allocating it to supposedly independent private partnerships. But the jet engine of Enron's share-price rise was not its asset and liability picture, but its otherworldly increase in revenue: Between 1996 and 2000, Enron reported an increase in sales from $13.3 billion to $100.8 billion.
To put Enron's 57% five-year sales growth rate in perspective, during that same period, Cisco Systems enjoyed a 41% sales growth rate. Intel's rate was 15%. In its creation of revenue, if not profit, Enron was truly the corporation from another planet.
Enron more than doubled its reported sales between 1999 and 2000. Before it declared bankruptcy, Enron said it was on track to double revenue again this year. Had it done so, it would have become the second-largest corporation in the world in terms of sales. It might even have edged Exxon Mobil (2000 sales: $206 billion) for the number-one slot.
Is it possible that Enron, a relatively obscure energy-trading company until six months ago, could be the world's largest by revenue?
No.
Enron's reported revenue was based on its exploitation of a loophole in accounting rules that allowed it to book revenue from huge energy-derivative contracts at their gross value, not their net value as is done with other securities transactions. To be fair, Enron's competitors such as Dynegy account for revenue the same way. The tactic may be legal, but few investors--and few Wall Street analysts--understood how Enron was booking revenue, even though the distorting technique is what allowed Enron to be billed as the "seventh-largest company in America."
Compare Enron's method to other traders: When Wall Street sells shares, it books only a tiny fraction of the revenue Enron and other energy traders would book. For instance, if a Merrill Lynch customer sells 10,000 shares of Wal-Mart stock through Merrill Lynch for, say, $500,000, Merrill would book the commission on the sale or the spread between the bid price and the ask price--perhaps $500. But an energy trader doing the same thing with an energy contract would book the full half-million, a difference of almost 1,000%!
How Enron appeared to outperform the world remains shrouded in mystery. Enron earned more than 90% of its revenue from a business it calls "wholesale services," Enron's euphemism for trading. Here is how its 2000 annual report describes that activity: "Enron builds wholesale businesses through the creation of networks involving selective asset ownership, contractual access to third-party assets and market-making activities."
The statement is characteristic. Enron's discussion of its finances reads like something written in German, translated to Chinese and back to English by way of Polish.
Enron's reported performance is even more incredible in context. As of 2000, Enron had 19,000 employees. Per employee, Enron says it generated $5.3 million in revenues. This figure more than triples Goldman Sachs, which generated $1.7 million per employee. The men and women of Enron made the monopolists at Microsoft (revenue per employee: $610,256) look like slackers. They put the workers of Citigroup ($469,748 per employee) and IBM ($283,333) to shame.
But beyond the trading of energy futures contracts back and forth--all with huge notational values--Enron's sales grew because it was a "market maker," serving as the middleman on deals. It would put a buyer together with a seller, take "delivery" of the contract for one fleeting moment and book the entire "sale" as revenue to Enron.
Enron was allowed to do this because a task force of the Financial Accounting Standards Board (FASB) could not decide how energy contracts should be accounted for, explains Douglas Carmichael, the Wollman distinguished professor of accounting at Baruch College. The board finally decided that each company had a "free option" as to how to account for the deals. Enron, of course, opted for the bigger numbers.
This action by the FASB was "a complete abdication of responsibility," Carmichael says. It violates a cardinal principal of accounting called representational faithfulness. "The notion in accounting is that similar economic circumstances should be treated the same way," Carmichael says. This notion was not widely respected at Enron.
Conversations with Wall Street analysts who covered Enron indicate they had little or no understanding of how Enron reported such huge numbers. Asked to compare how Enron or Dynegy book revenue with other businesses, most analysts say Enron was a trading business and that revenue was not important. Asked to compare the energy traders to securities firms, who are also engaged in trading, one stumbled for an answer and finally said, "You know, that's a really good question."
But the answer to the question, while not widely known beyond elite accounting circles is simple enough. It played its game by dint of trading for its own sake and accounting rules. This is why Enron's bankruptcy would have, in the words of Treasury Secretary Paul O'Neill, no "spillover effect."
An uncritical reading of Enron's inscrutable reports indicates it was running so much faster than everyone else. If an Olympic track coach hears a report that an unknown runner had broken the world record for the mile by two seconds, he might be skeptical or wonder if the runner was on drugs. But if he had heard that the runner had run a mile in three minutes flat, 45 seconds faster than everyone else, he'd refuse to believe it. He'd say it was impossible. Or he'd say the watch was broken. When Enron made equally unlikely pronouncements no one seems to have asked a question or thought twice.
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