What was wrong with Enron's financials?

[Nomad]

One of the exercises I find useful to address the problem of hindsight bias is to conduct a "de novo" review of past company filings prior to those companies' later writedowns, miscalculations, and strategic failures. Although I have been investing for several years now, I have to say that my knowledge of accounting has developed much more slowly than my knowledge of competitive dynamics and that accounting remains one of my weaker areas as an investor.

 

In an effort to expand my circle of competence, I want to take a look at Enron, Tyco, and WorldCom - the Holy Trinity of accounting scandals - from the vantage point of an investor during that time period. We all now "know" that Enron was a fraud, but what exactly was amiss with their financial statements? I have pulled up their 1998 - 2001 SEC filings in an effort to better understand what transpired, but I'm not sure I know exactly what I should be looking for.

 

Has anyone else undertaken this exercise? What are the red flags that I'm not seeing here? All I can say from my (admittedly cursory) review of their financials so far is that the company would belong in my "too hard" pile. What led smarter, wiser investors than me to the conclusion that their financial statements were likely manipulated?

[boilermaker75]

Was the reported FCF  negative those years?

[coc]

I would basically start by trying to “track the cash” over the years. Was there real cash coming in, and if so, how was it being allocated? Can you explain in plain English, and does it make sense to you? Was it self funded or dependent on capital markets? Was it earning its cost of capital?

 

What kind it accounting paradigm did they use? How did it look like they were making the money? Enron was a pioneer in the extensive use of “gain on sale” accounting and mark to market assumptions, which later haunted the financial industry.

 

Also try to calculate the return on assets for various divisions. Fraud aside, Enron was an atrocious business, which any fundamental analyst should have picked up.

 

Next check the footnotes.  Anything off? Confusing?

 

Lastly, read The Smartest Guys in the Room to understand what was being done behind the curtain. Detecting fraud is difficult and you have to think more like a detective (the dog that didn’t bark) than a financial analyst sometimes. It’s not obvious, and they public financial statements provide more clues than smoking guns, which are usually found later. Markopoulous presented the SEC extensive evidence that Madoff was a fraud and they didn’t even get it. 

 

[Nomad]

Was the reported FCF  negative those years?

 

Doesn't look like there's any massive FCF deficit, although I haven't delved extensively into the components listed in the statement of cash flows yet. Their 2000 Annual Report has been archived here: http://picker.uchicago.edu/Enron/EnronAnnualReport2000.pdf

 

Page 36 shows their cash flows and it appears at first glance like there's a huge jump in operating cash flow from 1999 to 2000.

[Nomad]

I would basically start by trying to “track the cash” over the years. Was there real cash coming in, and if so, how was it being allocated? Can you explain in plain English, and does it make sense to you? Was it self funded or dependent on capital markets? Was it earning its cost of capital?

 

Thank you! I'm going to delve deeper into their statement of cash flows to see if they were misclassifying certain investing / financing cash flows as cash from operating activities. This is where my accounting ability gets admittedly pretty weak, so it might take me awhile to understand everything (if I understand it at all). 

[writser]

Interesting exercise. For one thing, according to Wikipedia:

 

As was later discovered, many of Enron's recorded assets and profits were inflated or even wholly fraudulent and nonexistent. One example of fraudulent records was during 1999 when Enron promised to repay Merrill Lynch & Co.'s investment with interest in order to show a profit on its books. Debts and losses were put into entities formed "offshore" that were not included in the company's financial statements, and other sophisticated and arcane financial transactions between Enron and related companies were used to eliminate unprofitable entities from the company's books

 

So one question to consider a priori is: are the financials reliable in the first place? How relevant is it to study them?

 

But I guess there's probably something to learn. Some stuff I don't like after looking at the financials for a few minutes (with the benefit of hindsight, of course)

 

1) If anybody understands what is happening in footnote 16 of the financials they probably deserve a Nobel prize.

2) The balance sheet looks very precarious. Huge derivative positions 'assets / liabilities from price risk management activities'. No cash. During 2000 receivables / payables quadrupled. 5b in 'unconsolidated equity affiliates' with only very limited disclosure in footnote 9.

3) Cashflow: what is happening under operating cashflow at 'merchant assets' and why are the items there so big, in particular 'proceeds from merchant asset sales'? On page 40 these activities look relatively small.

4) from 1998 - 2000 shares outstanding and diluted shares outstanding increase ~7% annualized.

5) how sensible is a y/y revenue growth of 150% from 20b to 50b in what is basically a utility company?

 

These points do not necessarily indicate fraud but at the very least they make me a bit suspicious. At the very least, after looking at the financials I cannot say that I understand at all what is happening.

[coc]

So one question to consider a priori is: are the financials reliable in the first place? How relevant is it

These points do not necessarily indicate fraud but at the very least they make me a bit suspicious. At the very least, after looking at the financials I cannot say that I understand at all what is happening.

 

This is a really key thought to have. If you combine the idea that the business was simply not comprehensible with an actual business analysis showing how poor the results were, the lack of cash flow, and the constant dependence on the capital markets, consistently poor ROIC, plus the later footnotes indicating that a senior manager was doing deals with a private partnership he had an interest in, the indications of substantial off-balance sheet debt (well known in the analyst community), you are probably as far as you need to go to avoid or even short the stock.

 

Of course, the story was infinitely deeper. Fastow and Skilling were pathological and the  business was rotten, But it was hard to see all of that until the reporting was done.

 

You’ll note that stories like this (perhaps less extreme) still exist even post Enron.

[5xEBITDA]

Read the cash flow statement. In 2000, the net change in cash was approximately $1.0 billion. If you look closer to the line items, they recorded a gain of $1.8 billion from "proceeds from sales" and similar amounts the two years prior. Thats a weird line item. It's different than "proceeds from asset sales", its just...sales. What are these sales? Dig into that.

 

Another really weird thing about their financials is the following on their income statement.

 

Revenues:

 

1998: $31 billion

1999: $40 billion

2000: $101 billion

 

Operating Income:

 

1998: $1.4 billion

1999: $800 million

2000: $1.9 billion

 

That's very weird...revenue is exponentially growing, but operating income is not, and in fact margins are going down. How can you have so much more revenue coming in without cash following? I would read the revenue recognition policies in their annual report.

[Spekulatius]

Enron‘s balance sheet almost doubled in size from 1999 to 2000 from ~34B to $65B, while profits were relatively small. they had huge balance sheet items from trade receivables and assets from risk management activities showing up on their balance sheet (~12B and going up more than 5x).

 

Value investors would have never touched this, because it was just to expensive. I do know a few of them got sucked in on the way down though.

[Grafter]

Some of the other posters have hit upon some of the things that Enron did and some of the questions that should have been asked.  However, if you are really curious, I would highly suggest reading Financial Shenanigans: How to detect accounting gimmicks & frauds in financial reports, as they have sections about each of the companies you mentioned.

[Cigarbutt]

I had heard of Enron during the energy deregulation era and then it was surrounded by a halo of success.

I looked into it when Fairfax (through ORH) reported Enron-related losses (?bond losses) and when, for a while, some suggested that FFH was the next Enron.

 

When looking retrospectively and using accounting prisms elaborated after the fact, red flags are pretty obvious (revenue recognition, cashflow vs income, SPEs etc) but IMO only a few individuals could have spotted the extent of the fraud and have the courage to publicly voice concerns. There were some relevant and investigative-type questions asked by analysts but it's very hard to unsettle a stock market darling that reports audited results and obtains adequate credit ratings.

 

It's probably best to walk away from these potential situations using basic sniff (accounting or management trust) tests.

Financial Shenanigans by Mr. Schilit is a good book. Edit: I agree with Grafter.

The whole story about Enron though is fascinating (human nature etc).

 

For the opening poster, Nomad, I have a few pages from the CFA level I and II program that deal specifically with the Enron post-mortem accounting analysis and something can be done privately.

[writser]

Financial Shenanigans by Mr. Schilit is a good book.

 

Yes, recommended.

[Guest cherzeca]

this is a worthwhile pursuit, ex post analysis, but I think it is very hard to develop an expertise in detecting ex ante accounting BS.  while detecting disconnects between profits and cash flow is the linchpin, there is just a lot of dead ends that you may end up in when companies use VIEs and unique arrangements (why did the cfo set up all of these subs that he was in charge of...?).

 

the difference between then and now that interests me is social media.  while financial twitter is generally a mess, I think there can be some interesting tidbits.  the whole $tslaq thread has some interesting vehicle delivery tweets that can be measured against musk's bravado...at least when he was still tweeting.  you never know when you will find gold in your pan, and I think following some of the twitter noise may lead you to some interesting signals.

 

and of course, just following the 13Fs of guys like Einhorn is another way to sniff stuff out.  Einhorn and the short community like to talk to each other

[Guest Schwab711]

I think the whole point of Enron is there wasn't enough information to know there were issues. That's at least some of the reason for expanded disclosure in Sarbanes-Oxley and the dissolution of Arthur Anderson. My understanding is Enron didn't look to be generating operating profits and no one could describe how they earned their trading profits (Chanos/McLean thesis). The related party transactions were complex and potentially pointed to accounting issues (Chanos). In reality, they hinted at what was later known as the Raptor transactions (the empty shells hiding debt).

 

I believe both Bethany McLean and Jim Chanos, famous for calling out Enron before the fall, both believed Enron was overvalued because of unsustainable profit origin and potentially untrustworthy numbers, but not necessarily fraud. Without the whistleblower, I'm not sure the Enron story is the same (though they would have failed eventually from their own losses).

 

In hindsight, you can definitely see that trading IBIT exceeds the group's IBIT, which points to what Chanos/McLean saw. At the peak, Enron was valued at something like 7x P/B and 55x IBIT (which was more than 100% trading profits). Further, p.39 (slide 41/60) shows the assets quality of the price risk management assets. Enron had 4x the PRM assets with a 25% increase in reserves. Roughly 25% of their $21.5b of PRM was non-IG. This was another hint that the trading profits were probably not sustainable.

 

Even if the numbers were real, the argument at the time was that the valuation didn't match the underlying company.

 

McLean's famous article:

http://archive.fortune.com/magazines/fortune/fortune_archive/2001/03/05/297833/index.htm

 

Whistleblower:

https://www.theguardian.com/business/2003/jun/21/corporatefraud.enron

 

 

[SharperDingaan]

Almost always these things are the result of an ill-conceived change in an accounting standard; in this case, the standards around securitization. At the time the entire profit on a 20 year securitization deal, could be booked as profit on day-1; today you can only book profit as you earn it.

 

Of course an accountant has to find the anomoly, an analyst has to call it, and it is in neither parties interest; until there is more to be made on the way down, versus the way up. Hence it is a rigged game; and it is to you (the investor) to both realize that, and realize that it cannot be pumped without promotion. These companies are 'market darlings' for a reason.

 

Point is, that unless you are a forensic accountant, you are not going to detect them.

 

SD

 

 

[Guest cherzeca]

@sd

 

except Enron was booking profit for handshake joint ventures some of which were never documented much less actually put begin operations.  you can't find this kind of fraud looking at financial reports

[coc]

Important to note: understanding the public filings will probably not let you conclude fraud in and of itself. It’s only part of a puzzle. But unless the fraud is extremely clever, and Enron wasn’t, they should give you strong hints that all was not well. It’s not necessary to have a full picture of the fraud to know what to avoid. Chesapeake Energy is a good recent example - perhaps not fraud, but very problematic in some ways familiar to the Enron story. (Hiding debt, hiding payments etc)

 

It’s also worth looking at Azurix, which Enron IPOed and then had to buy back.

Another total sh*tshow.

 

https://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=0001080205&type=10-k&dateb=&owner=exclude&count=40

 

 

[SharperDingaan]

The reality is that looking at financials is only going to catch the bad or incompetent, the visible part of the iceberg.

Think about how business is actually done in most places in the world; where's the line on the P&L entitled 'bribes'? And have you ever seen an account entitled 'bribes', in a general ledger? We simply call bribes something else - making 'covering up' an every-day part of business. The deciding factor is a judgement call, subject to incentivization.

 

SD

[coc]

I forgot to include this report in my prior posts - written by a great analyst / short seller named Mark Roberts in 2001 before Enron collapsed. He pretty well outlines everything you should/would have found in the filings — which again, were the tip of the iceberg, but as his report shows, more than enough.

 

https://www.offwallstreet.com/userfiles/files/ideas/NEW_ENE_5_6_01.pdf

[Guest cherzeca]

I forgot to include this report in my prior posts - written by a great analyst / short seller named Mark Roberts in 2001 before Enron collapsed. He pretty well outlines everything you should/would have found in the filings — which again, were the tip of the iceberg, but as his report shows, more than enough.

 

https://www.offwallstreet.com/userfiles/files/ideas/NEW_ENE_5_6_01.pdf

 

outstanding work

[writser]

Cool to read that report. Thanks.

 

Fascinating to see: the author seems to have a decent grasp of what is happening. He asserts Enron is not generating FCF, is skeptical about the related party transactions, even noting "These are, in effect, sales with recourse to Enron. It is unclear to what degree Enron is actually exposed to these recourse arrangements.". He notes that Enron marks investments using questionable models, is questioning the merchant asset trading profits, etc. But in the end he still comes up with a $30 / share or 26b valuation. A few months before bankruptcy! In hindsight it is easy to make fun of this, but at the time I'm not so sure I'd have done better. Very hard not to anchor to the current valuation.

 

This was a fun exercise and funnily enough a bit reassuring. Could I have predicted Enron was a fraud before the fact? I doubt it. Would I have been smart / ballsy enough to short it? I doubt it. But after looking at the financials for a few minutes I can say with some confidence that I would not have gone long either. Not my cup of tea. Share count increasing like crazy, selling insiders, opaque and risky balance sheet, unclear where cashflow / earnings come from, huge derivative positions, very dubious related party transactions combined with a rich valuation: I think that Enron, just like Valeant, would be on my "skeptical-but-too-hard-pile" within a few minutes, meaning I would post snarky comments from the sidelines without ever getting involved. I guess that means I'm just a very boring, conservative investor, missing out on all the fun.

[coc]

writser,

 

The “skeptical-but-too-hard” pile is just about the most important pile to have, in my judgment. You don’t have to get them all right.

 

I’ll also add that Chanos has said before that he thought Enron was just a bad business, overpriced, overcomplex, overlevered - he didn’t know the numbers were so cooked until after the trials.

[Spekulatius]

I look at the records from my old message board and it was clear to most of us, that first ENE was overpriced, but also risky. The derivatives and trading shenanigans were sort of known (Pg&E bankruptcy). Proving fraud is very hard, but yellow and red flags were quite possible to detect. Same is true for many other frauds that came up later. Just avoiding stocks with similat traits that show yellow flags will not get you into this mess, but you will miss some opportunities to make money as well of course.

[writser]

https://ftalphaville.ft.com/2020/02/12/1581518847000/Enron--blast-from-the-past/

 

Good read. Links to some really nerdy in-depth analysis of the Enron fiancials: http://archives.cpajournal.com/2003/0403/features/f042403.htm .

[LongHaul]

I would read  Howard Schilit's Financial Shenanigans for some insights generally into frauds and some color on each of the 3 companies you mentioned.