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Lessons from Enron
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November 28, 2001: 7:03 p.m. ET
The collapse of Enron is hard to believe -- and even harder to understand. But in retrospect, there are some valuable lessons in the whole mess.
By Michael Sivy
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NEW YORK (CNN/Money) - "Never eat at any place called Mom's or play cards with any guy named Doc," Chicago novelist Nelson Algren advised. Those words won't help you choose a restaurant or win a card game. But at least they're a reminder not to walk blindly into situations where you're going to end up being the mark. So when my editor asked me to draw some lessons from the Enron debacle, I figured that if I could come anywhere close to Algren, I'd be doing pretty well.
First, let's just take a moment of silence to register the sheer scale of the Enron disaster. $85 to 65 cents in less than a year. That's like something from a television sitcom. Even more incredible, there were a fair number of analysts recommending the stock even after it was down 95 percent. One poor fellow actually downgraded the stock from "strong buy" to "hold" on Wednesday. And top mutual fund companies, such as Janus, were major shareholders as recently as the end of the third quarter.
For the record, I recommended Enron a few times during its big runup from $18 in 1997 to $90 in 2000. When the share price got scarily high, I just stopped writing about it, and never suggested that anyone sell.
Here are the facts of the case. In 1985, Houston Natural Gas merged with InterNorth to form Enron, a major interstate and intrastate natural gas pipeline company. In 1989, the company began trading natural gas. In 1994, the company began trading electricity. By 2000, 95 percent of revenues and more than 80 percent of profits came from wholesale energy operations.
Enron's success in trading energy using ever more sophisticated strategies promised earnings growth of as much as 25 percent a year. There were just a few problems.
First, the company's return on equity was no more than 13 percent for most of the late 1990s -- and that kind of ROE would normally support earnings growth of only 10 to 12 percent a year.
A second problem was that Enron's business increasingly relied on sophisticated trading deals, the full details of which were not always revealed. Analysts admitted that they didn't always understand what the company was doing and that they took the company at its word on what earnings were. What was clear, however, was that the company was taking on lots of debt -- whether that was a result of rapidly expanded trading or a sign that the deals weren't as profitable as Enron said, no one could tell.
Eventually, the SEC began investigating Enron, and in November Enron revised financial statements for the past five years. The company then reached a deal to sell out to its rival Dynegy -- and that deal has just fallen apart.
Reflecting on this whole sorry tale, what conclusions can we draw? The old Warren Buffett advice that you should only invest in businesses that you understand is a good place to start.
But I think there are two other issues that are worth thinking about. I would be careful of any company that suddenly starts growing faster than its historical norm but doesn't have the ROE to sustain that growth internally. There are legitimate firms that grow for a long time on borrowed money. But it's always better if the company is financing much of its growth by reinvesting profits.
Secondly, I'd be cautious about any business where the selling and the financial engineering are not separate. These two activities normally act as checks and balances on each other -- the selling side tries to maximize revenues and market share while the financial side only allows sales to creditworthy customers. When the two activities are commingled -- through derivatives, futures, guarantees and options or preferential lending, there's a chance of trouble.
Corporations such as General Electric and Ford have profited enormously from their captive-lending subsidiaries, which earned substantial profits as well as supporting sales of the companies' products. So I'm not saying such arrangements are always a bad thing. But wherever sales and financial dealmaking are not kept completely separate, be cautious.
The advice: Earnings can't be created out of nothing. You don't have to understand all the details of a company's business. But you do need to understand how reported margins, ROE and debt levels actually produce the results the company reports. Be skeptical of companies that are too successful too fast and that don't have visible fundamentals to explain why. And never eat at any place called Mom's.
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