Salter: Enron was an innovative company, and its downfall can be traced to supreme arrogance bred by considerable success, some extremely poor diversification decisions, and poorly conceived and implemented administrative practices that led, over time, to reckless gambling and ethical drift.
This drift was facilitated by Enron's bankers and advisors and largely missed by its board of directors and other watchdogs. Here are some "high level" details:. In , Skilling was named CEO. Before , Enron was an innovative and profitable player in the newly deregulated natural gas industry. Skilling's big idea was to create fluid and transparent markets for commodities like natural gas that were burdened with highly inefficient delivery systems.
In time, the company supported his basic concept with EnronOnline, a Web-based trading platform that instantly became the world's largest e-commerce system in Skilling also created what was known as a gas bank to provide a "reserve requirement" to back up supply commitments. Enron had a major advantage over competitors as a middleman between producers and consumers because it operated one of the nation's largest natural gas pipeline networks.
These innovations enabled Enron to develop and run a futures market for natural gas, and to create derivative supply contracts that could help customers manage the risks of demand volatility and price swings more effectively than before. In this way, Skilling and his colleagues solved a major contracting problem between the producers and the users of natural gas, and the rewards were great. This initial success prompted Enron to extrapolate its business model to other markets.
In , Enron officials started trading wholesale electricity after Congress deregulated the industry; Enron analysts estimated the electricity market to be 10 times larger than the natural gas market. Diversification into water utilities and broadband soon followed, as did expansion to other countries that promised to deregulate and privatize energy production and distribution.
Unfortunately, applying the company's middleman skills to other commodities and developing power projects in diverse markets proved a significant challenge. Still, supreme overconfidence and perverse financial incentives led to a gladiator culture in which executives proposed—and risk managers and the board of directors approved—a growing number of risky gambles with high expected returns.
Meanwhile, building on intense lobbying to encourage further domestic deregulation and limit federal oversight of the energy industry, Skilling encouraged Enron executives to exploit to the hilt recent Securities and Exchange Commission rule changes as well as then-current tax rules. Many of Enron's investment gambles failed to satisfy its voracious appetite for cash to support its commodity-trading operations, and in , profits declined.
This prompted the company to sell overvalued, underperforming assets to off-balance-sheet partnerships controlled by chief financial officer Andy Fastow—a conflict of interest approved by the board. The idea was to use these mind-numbingly complex entities to manage reported earnings, minimize reported debt, and maintain the company's all-important credit rating and overvalued stock price.
Enron also used the off-balance-sheet entities to hedge its more successful investments—to avoid having to report any declines in their value. The problem was that many of these hedges were not real, because Enron was essentially hedging with itself. To help disguise the company's deteriorating financial position, many outside advisors and bankers either colluded in or acquiesced to these questionable transactions. Enron's sophisticated risk analysis and control system also experienced serious breakdowns.
These breakdowns, along with management's increasing aversion to truth telling, isolated the board from many evolving realities. In addition, Enron's supernormal growth and skyrocketing stock price made it difficult for most directors to challenge management's strategy and tactics. Still, board members understood that Enron was trying to move underperforming assets and potential investment losses off its balance sheet.
Red flags should have alerted them to the fact that the company was short of cash as well as profits. Yet Enron's board failed to detect and prevent violations of accounting principles and rules. In the third week of October , Arthur Andersen, Enron's highly compromised outside auditor, "discovered" several large accounting irregularities related to the off-balance-sheet partnerships. Within weeks, Enron collapsed into bankruptcy as its trading partners quickly lost faith—proving, once again, that even a hint of negligence or misconduct can be devastating to a company.
Thanks to its heavy involvement with commodity derivative trading and Enron Online, Enron had a very complicated business model that many investors did not fully understand.
Second, unintelligible footnotes usually indicate untrustworthy management. This observation can be generalized to other common stock investments. This is a belief that legendary investor also Peter Lynch held very strongly:.
Using accounting for fraud and folly is a disgrace. In a democracy, it often takes a scandal to trigger reform.
Enron was the most obvious example of a business culture gone wrong in a long, long time. In particular, caution should be exercised when a business makes extensive use of non-GAAP financial metrics. For a company with a large amount of money invested in fixed assets think railroads , telecommunications providers, utilities, and energy infrastructure companies depreciation is a very real expense, and ignoring it is not likely a wise decision.
Warren Buffett extends this belief to all companies not just the capital-intensive examples shown above. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business.
Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service in the way they would lay out cash for a fixed asset to be useful for ten years. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?
For other, more capital-light business models like asset managers or banks , EBITDA will tend to be closer to earnings. Aside from the use of non-GAAP financial metrics, investors should be wary of flashy or distracting investor presentations. B BRK. Berkshire investor documents and conference calls are also completely devoid of forecasts for earnings, cash flow, and other financial metrics adored by Wall Street analysts. We are suspicious of those CEOs who regularly claim they do know the future — and we become downright incredulous if they consistently reach their declared targets.
Enron has built unique and strong businesses that have tremendous opportunities for growth. These businesses — wholesale services, retail energy services, broadband services and transportation services — can be significantly expanded within their very large existing markets and extended to new markets with enormous growth potential.
At a minimum, we see our market opportunities company-wide tripling over the next five years. This underscores the risk of blindly believing corporate growth forecasts. These two characteristics should be viewed as red flag in potential stock market investments.
Buffett — known for conservative risk management and a long-term track record of market-crushing returns — has the following to say about derivative trading:. Investors would be well served to heavily scrutinize any investments in companies that rely on derivatives and other complicated financial instruments to generate earnings.
Source: Enron Annual Report , page Some additional quick math shows that Enron had a debt-to-equity ratio of 4. The takeaway from this observation is to avoid businesses that have volatile business models and excessive levels of debt.
In fact, high debt levels can be used to fuel growth for businesses with very stable business models. If the debt a company uses is cheap a reasonably low interest rate and the underlying business model is predictable and stable think telecommunications companies, branded consumer goods companies, etc.
There are generally two scenarios where leverage should definitely not be used while investing:. For context, the yield on the year U. Treasury Bill was 5. By and large, this is because they did not properly assess the counterparty risk that they assumed when entering agreements with Enron.
Counterparty risk is a risk to both parties and should be considered when evaluating a contract. There are many different types of counterparties that suffered financial losses after the Enron scandal. Arthur Anderson had the same problems with the Baptist Foundation of Arizona several years earlier when million in assets was more like million in assets because most of the assets booked by the Baptist Foundation were found to be substantially overvalued.
Other companies to look at: Cendant, RiteAid, and Sunbeam. Could Enron have been prevented? May 1, Share This Post. Share on facebook. Share on linkedin. Share on twitter. Share on email. Next Who are the bad guys? More To Explore. September 13,
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