How 287 Turned Into 7: Lessons in Fuzzy Math
nytimes.com
January 20, 2002
BUSINESS
By GRETCHEN MORGENSON
or years, the Enron Corporation (news/quote) was known and admired as one of the nation's most innovative companies. Now, it looks as if the only innovations the company will be remembered for are the many labyrinthine schemes it used to mislead investors about its financial position.
It is not yet clear how early and often Enron substituted fantasy for reality in its reports to shareholders. But knowing the extent of the dishonesty is central to answering the question many people asked as they watched Enron implode. How could a company as big, profitable and powerful as Enron slide into oblivion so quickly?
Part of the answer is that Enron was neither as large nor as profitable as it claimed. But the company was a master of obfuscation in its financial statements, so investors were kept pretty much in the dark about its stature.
For example, the company said it was a highly profitable enterprise. But a determined investor looking closely at its financial statements would have found that even in the California power crisis, when energy costs were in the stratosphere and profits should have rolled in, Enron was earning only one-half of 1 percent on its sales.
Another half-truth concerned Enron's appearance last year at No. 7 on the Fortune 500 list of largest American companies. The company's $101 billion in revenue placed it between the powerhouses Citigroup (news/quote) and I.B.M. (news/quote) on the list. But rising to that level occurred only because energy trading companies can record as revenue the total amount of their transactions, rather than the profits made on each trade as is typical at brokerage firms. If viewed this way, Enron's revenue would have been $6.3 billion last year, pushing it to the bottom half of the list, at No. 287, wedged between Automatic Data Processing (news/quote) and Campbell Soup (news/quote).
Adding credibility to the view that Enron was more ephemeral than real was last week's announcement that UBS was taking over the company's vaunted trading business, and paying nothing up front.
"We don't know where reality sets in at Enron," said Robert F. McCullough, an authority on the electric utility industry at McCullough Research, a consulting firm in Portland, Ore. "We know that the operational numbers as far as we can follow them don't scan. We have 4,000-odd special-purpose entities off the balance sheet. We're having very grave doubts about the overall honesty of the company. The question is, How far down did that dishonesty extend?"
It may take a team of forensic accountants months if not years to unravel all the Enron entities and see where the $12.5 billion that the company raised in the capital markets over the last 10 years went.
Nevertheless, for investors hoping to learn from the Enron wreck, a look back at its recent financial statements, fuzzy though they were, does show several warning signs of some of the company's woes well before the bottom fell out last fall. Investors concerned that other Enrons may be lurking in the stock market's shadows can sharpen their pencils and conduct a few tests on financial statements to allay or confirm their fears.
Michael J. Maubossin, chief United States investment strategist at Credit Suisse First Boston, said Enron was, to some degree, a victim of its own growth promises. Even as the company was convincing investors that its impressive revenue growth would translate into extremely profitable businesses, Enron was unable to produce the returns that investors demanded.
"The reason people had enthusiasm for Enron was you could have made the case that they were in nascent markets that were going to develop into solid ones," Mr. Maubossin said. "But the economics were not there. As Enron needed more capital, the company went to more byzantine financial structures to try to achieve the growth it needed."
In Enron's days as a stock market darling, there was almost nothing it could say that investors wouldn't believe. One claim that caught the eye of Mr. McCullough well before Enron collapsed last year involved the commercial success of Enron Online, the company's online trading business. During 18 months that ended in the company's third quarter, even as other dot-coms went bankrupt, retrenched or simply vanished, revenue at Enron Online grew at an astonishing 12 percent a month.
A particularly doubtful assertion made by Enron Online was the so- called notional revenue it reported, Mr. McCullough said. For the first nine months of 2001, in news releases, Enron Online reported $544 billion in notional revenue, or the total amount of the underlying gas and electricity that the operation's trades covered. Yet, this contrasts greatly with the energy purchases and sales that Enron reported in its filings with the Federal Energy Regulatory Commission for the same period. Those reports show just $693 million in energy purchases and sales by the company. "We compare that $693 million against $544 billion and it's a surprising number," Mr. McCullough said. It is also a dubious number, he added. "A normal utility would have total electric revenues in the $1-to-$2-billion range, so the Enron number is roughly equivalent to the amount of electricity generated by 500 large utility companies. But they never put any of these numbers side by side so people would begin to question the numbers."
Few investors can be expected to have done the extensive work Mr. McCullough did to uncover suspicious figures in Enron's reports. But by comparing two figures found in Enron's annual reports, even a novice could have found reason to doubt the earnings the company was reporting in recent years.
According to Enron's 2000 annual report, which does not reflect the four years of earnings restatements the company announced in October, net income rose to $979 million in 2000 from $703 million in 1998, an increase of 39 percent. Total earnings for the three years came in at $2.575 billion.
As is now known, these profits were almost completely manufactured. But even before the dire restatement of last fall, investors on the lookout for wide discrepancies between a company's reported earnings and its retained earnings — the profits that it made after all expenses and costs, like stock dividends, were paid — would have noticed a gulf at Enron.
For 1998 through 2000, Enron's net retained earnings, after subtracting losses from its trading activities, totaled just $474 million, roughly $2 billion less than its reported profits.
What this exercise illustrates is the amount of puffery that can go into a company's income statement. Retained earnings, found in a company's statement of changes in shareholder equity, are not as closely watched by investors as are a company's net earnings, but they are less easily manipulated. |
