Enron Needs to Fix Its Short-Circuits

After a huge third-quarter loss and a possible conflict of interest, the energy giant has to come clean with investors

By Heesun Wee

Houston-based Enron Corp. (ENE ), which transformed itself from a sleepy utility to a powerful Wall Street energy darling as it became North America's largest buyer and seller of natural gas and electricity, hasn't been able to stay out of the headlines lately. And the news hasn't been good.

Since mid-October, Enron has reported a $618 million loss for the third quarter, resulting from $1 billion in previously undisclosed write-offs. The company also announced a $1.2 billion reduction in shareholder equity for the quarter, following the termination of complex transactions between Enron and limited partnerships that until recently were headed by Andrew S. Fastow, Enron's former chief financial officer. Fastow was replaced on Oct. 24, just 24 hours after Enron CEO Kenneth Lay had publicly voiced confidence in him.

The unusual transactions raised eyebrows among investors and on the Street about potential conflicts of interest. Why was the CFO personally engaged in complicated hedging transactions involving company assets and millions of Enron shares? The Securities & Exchange Commission has begun collecting information relating to the transactions, although the company says it has done nothing wrong. "This is not an investigation, and we are cooperating with [the SEC] fully," says Karen Dene, an Enron spokeswoman. "And we look forward to putting this matter to rest."


  Wall Street clearly has been rattled by the revelations. The stock is trading around $15 a share, 82% off its 52-week high of nearly $85 hit last December. "The decision by senior management and the board to allow the CFO to have a personal stake in a related party that was doing transactions with Enron was just poor judgment," says Andre Meade, an analyst who follows Enron at Commerzbank Securities.

New concerns are mounting about Enron's liquidity -- a shocking turn for this once blue-chip energy company. On Oct. 25, it drew down its credit lines to provide cash liquidity "in excess of $1 billion," according to a company statement. "We are making it clear Enron has the support of its banks and more than adequate liquidity to assure our customers that we can fulfill our commitments in the ordinary course of business," newly appointed CFO Jeff McMahon said in a statement.

It's the first crucial step Enron must take to forcefully restore the confidence of investors, Wall Street, and the energy community. The liquidity issue is crucial for a company that relies heavily on its credit lines to conduct billions in dollars worth of trading deals on a daily basis. On Oct. 24 alone, Enron conducted $4 billion in transactions through its trading unit EnronOnline, a system widely used by energy traders.


  "Enron has been pivotal in developing the market over the past 10 years. They're just a large player in the market, and you can't stop trading with them. But everyday we're watching the developments," says Jeffrey Foose, managing director of trading at PSEG, a New Jersey-based parent of utility PSE&G.

The risk of a credit crunch developing would be a major blow not only to Enron but potentially to the entire energy market because Enron is such a big player. "If Enron can't play in the market because it can't access credit, what happens to the markets? That's scary," says Glen Hilton, a San Francisco-based portfolio manager for the Montgomery New Power Fund, who holds a position in Enron.

However, that possibility has been raised. So far, credit-rating agency Fitch has placed Enron on a possible downgrade. Standard & Poor's changed Enron's credit outlook to negative from stable. And Moody's Investors Service has said it's looking at a possible downgrade.


  In addition to restoring confidence, Enron also must refocus aggressively on its core competencies, analysts say -- its wholesale trading and retail energy operations. Just in the first quarter of 2001, volume growth in Enron's wholesale business was up 65% compared to the same period a year earlier. Also during the first quarter, Enron's retail energy-services unit recorded a profit of $40 million, excluding various charges, compared to $6 million in restated results for the same quarter in 2000.

"What they did best was trading and marketing energy commodities, and they tried to transfer these skills, and they haven't panned out," Meade adds. In the past several months, Enron has acknowledged missteps in its broadband unit, technical glitches at its Dahbol power plant in India, and a multimillion-dollar write-off resulting from its investment in Azurix Corp., a water company Enron spun off and then repurchased. It also made costly bets on energy markets in Latin America that so far haven't delivered the anticipated rate of return, the analysts say.

"[CEO Lay] is under the gun. He's back defending the company that he by and large built," says Hilton. Indeed. It was Lay who together with former CEO Jeffrey Skilling transformed Enron from a regional natural-gas pipeline company into the world's largest energy-trading company. (Skilling resigned unexpectedly on Aug. 14 for undisclosed "personal reasons" after only six months at the helm.)


  By the time the nation's electricity markets began opening to competition in the early 1990s, Enron already knew how to capitalize on deregulated markets because it accumulated valuable experience when the natural-gas industry underwent a similar transformation a decade earlier. When electric-power deregulation finally hit, Enron had the first-mover advantage and was off and running, while many of its peers still were trying to get their boundaries.

Strategies aside, many on Wall Street also are rightly urging Enron to come clean as quickly as possible about any other surprise write-offs that might show up on future financial statements. "There really is a need for much more disclosure," said David Fleischer, who covers the stock for Goldman Sachs & Co., during a conference call on Oct. 23 with management.

"There's an appearance you're hiding something," Fleischer, said to Lay on the call. The Enron CEO said he's aware of the concerns and that the company would offer updates using its Web site and possibly host additional calls in the future. He emphasized that Enron is limited in the information it can release given the ongoing dealings with the SEC.

A year ago when Enron's stock was riding high, the company could do no wrong. With Skilling promoting the company's broadband investments as worth $30 a share alone -- investors and many analysts were content with the limited amount of financial details the company offered. But that has changed, perhaps for good.

Wee covers energy and the financial markets for BusinessWeek Online in New York

Edited by Beth Belton

Before it's here, it's on the Bloomberg Terminal.