Enron's Departure from Core Business Takes a Toll on Performance ,
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[IMAGE]
October 22, 2001=20
Enron's Departure from Core Business
Takes a Toll on Performance =20
By Will McNamara
Director, Electric Industry Analysis=20

[IMAGE]
[News item from Reuters] Enron Corp. (NYSE: ENE) stock sustained further he=
avy losses on October 19 as investor confidence in the former Wall Street f=
avorite remained at a low ebb after it reported its first quarterly loss in=
 over four years. The energy giant's stock was off $3.32 or 11.45 percent a=
t $25.68 per share at mid-day trade on Oct. 19, making a cumulative loss of=
 28 percent for a week in which it reported a third-quarter loss of $638 mi=
llion. As of early morning trading on Oct. 22, Enron shares were priced at =
$21.99, a reflection of new developments (including a new Securities and Ex=
change inquiry) that have caused uncertainty about the company among invest=
ors.=20
Analysis: Enron's first financial report since the departure of former CEO =
Jeffrey Skilling in August has not done much to once again instill investor=
 confidence in the company, which has experienced one of its most turbulent=
 years in recent memory. While Skilling cited personal reasons for his depa=
rture, many analysts suspected that a significant drop in Enron's share pri=
ce and financial losses in its diversified businesses also played a role. A=
t the time of Skilling's departure, Enron's stock had tumbled to a 52-week =
low. However, based on the new 3Q report, it now appears that Enron's downw=
ard turn may be continuing despite the return of Kenneth Lay to the company=
's top spot. In essence, Enron's financial problems have been caused by bus=
inesses that the company has established as a way to diversify from its cor=
e focus on wholesale power sales. It appears that Enron is learning a costl=
y lesson-namely that investors are not responding favorably to the company'=
s innovation, especially if bottom line performance is in any way compromis=
ed. The road ahead may remain uncertain for Enron, as a good number of unre=
solved issues and a new Securities and Exchange Commission (SEC) inquiry in=
to financial dealings of its chief financial officer continue to overshadow=
 the company.=20
Let's first establish the financial losses that Enron has reported in the t=
hird quarter. As noted, as a whole the company reported $638 million in los=
ses, after taking $1.01 billion in charges associated with several of its n=
on-core businesses. When we break down the losses, it becomes clear that En=
ron is struggling with its operations in three businesses: water, broadband=
 and the retail power market. Specifically, Enron reported $287 million in =
charges from Azurix, its water and wastewater business; $180 million in cha=
rges related to the downsizing of its broadband operations (including sever=
ance costs and losses on inventory sales and customer contracts); and $544 =
million in what the company is calling "investment losses." Evidently, abou=
t half of the $544-million figure is related to Enron's investment in NewPo=
wer Company, the retail electricity and natural-gas provider that Enron lau=
nched about two years ago with partners America Online and IBM. Enron owns =
45 percent of NewPower. In addition, Enron's debt to total capitalization r=
atio reportedly will increase to about 50 percent, although Lay says that p=
ending asset sales may reduce that amount to 40 percent by the end of 2002.=
 However, it is important to note that Enron's 3Q recurring net income (bef=
ore the write-offs) did increase 35 percent to $393 million, or 43 cents a =
diluted share, and revenue in the quarter rose to $47.6 billion from $30 bi=
llion in 3Q 2000.=20
The losses associated with NewPower are particularly interesting. As one of=
 the leading investors in the company, Enron drove NewPower's aggressive bu=
siness focus on retail residential power sales, despite ongoing concerns ab=
out the development of retail competition across the United States. NewPowe=
r went public last year at an opening price of $21, and in the early days o=
f its initial public offering was trading above that price. However, the co=
mpany's stock has experienced a devastating drop in value, and is currently=
 priced at $1.25. NewPower is not scheduled to release its own 3Q financial=
 statement until early November, but it is expected that the company will c=
ontinue to incur significant losses for the foreseeable future. Specificall=
y, NewPower recently reiterated its earlier expectations of a 3Q loss of $6=
5 million to $70 million, or $1.12 to $1.20 a share. Third-quarter revenue =
reportedly will be slightly lower than the $60 million to $65 million that =
the company had forecast in August. =20
In analyzing NewPower's 2Q financial losses (see IssueAlert from 8/8/01 at =
www.scientech.com/rci ), I argued that the company is really struggling fro=
m a mix of positive and negative factors in its efforts to become the leadi=
ng retail energy provider in residential and small business markets in the =
United States. On the positive side, NewPower has recently secured a large =
number of new customer accounts, most significantly from its purchase of cu=
stomers and related assets from AES Corp. and DTE Energy. These purchases p=
rompted an impressive growth spurt for NewPower, and the company reportedly=
 now has a customer base in 22 markets in 10 states. However, the bad news =
for NewPower is that its losses continue to widen, apparently resulting fro=
m a combination of weather factors and financial hits absorbed in several o=
f the states in which the company operates. This dichotomy does not appear =
to be getting any better, and the company's stock has continued to drop as =
a result.=20
In an effort to alleviate some of its financial woes, NewPower recently rev=
ised an existing master netting agreement with Enron Corp. and several of i=
ts subsidiaries. The revised agreement essentially lowers the amount of cas=
h collateral that NewPower is required to post to the Enron subsidiaries th=
rough Jan. 4, 2002. With the lowered financial obligations that it must mak=
e to Enron, NewPower believes that it will have sufficient financial resour=
ces to conduct its business in the near term until it secures ongoing asset=
-based financing.  =20
However, from Enron's perspective, the losses associated with NewPower (and=
, by the same token, the losses in water and broadband) have contributed to=
 a steady drop in its own stock price. The message is clear: The businesses=
 that Enron plunged into as a way to diversify have tainted the company as =
a whole. Further, what some analysts perceived as brash hubris on Enron's p=
art has not translated into measurable profits, and consequently Wall Stree=
t has reacted by sending Enron's stock to a level that is about half of whe=
re it was a year ago. The individual sectors that Enron has pursued are all=
 unique, but they share the common denominator of taking Enron away from wh=
at was a successful core business. Further, they are similar in that Enron =
aggressively sunk large sums of capital into new business lines for which i=
t arguably had unrealistic expectations for growth. The problem with Enron'=
s bandwidth unit is that the company has faced an unanticipated excess of f=
iber-optic lines, which has prevented the demand for the division's service=
s from materializing as anticipated. The problem with Azurix, which has bee=
n losing money since its formation in 1998, is that privatization of the wa=
ter sector has not materialized as quickly as Enron and other companies ant=
icipated. In addition to these problem areas, Enron also faces challenges r=
elated to its investments in India (where it is locked into a legal battle =
with the state government) and California (from which Enron has yet to rece=
ive full payment for previous power sales). =20
In addition to the losses outlined in the 3Q report, there are new issues t=
hat are brewing at the start of this week. First, the SEC has requested tha=
t Enron provide information regarding "certain related party transactions."=
 Not much additional information is presently available about this inquiry.=
 However, it is probably connected to earlier reports about concerns relate=
d to the dealings of Enron's Chief Financial Officer Andrew Fastow, who up =
until very recently had run a limited partnership that bought assets from E=
nron. Ken Lay has said that Enron will cooperate fully with the SEC's reque=
st. In a separate development, several mutual funds (including AIM Constell=
ation that once held large positions in Enron) have either liquidated or re=
duced their holdings in the company, which has further weakened Enron's sto=
ck value. Portfolio managers of the mutual funds have cited concerns about =
Enron's ability to balance its new businesses with its core strength as an =
energy trader.=20
The present challenge for Enron is to convince investors that the company r=
emains on solid ground despite the losses. Thus, Lay has been quick to reit=
erate that earnings from the company's energy and gas-pipeline business are=
 still strong. Further, Lay says that the charges reported in the third qua=
rter should be seen as a way to "clear away issues that have clouded the pe=
rformance and earnings potential of our core energy businesses." Neverthele=
ss, the fact remains that Enron has invested huge amounts of money toward i=
ts diversification effort, and in addition to water and broadband the compa=
ny has invested into the steel and pulp and paper sectors as well. Thus, se=
veral questions remain at this juncture. Are the losses reported in the thi=
rd quarter only a temporary setback for Enron that will clear the way for t=
he company to return to a primary focus on its core business of energy trad=
ing? Or, will the losses continue into the fourth quarter and 2002? Moving =
forward, will Enron once again reshape its business model and eliminate the=
 various businesses to which investors have reacted less than favorably? On=
ly time will tell as the industry continues to watch the developments at En=
ron, which is clearly a company in the midst of another wave of change.=20

An archive list of previous IssueAlerts is available atwww.scientech.com=20

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