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Is Enron Overpriced?
It's in a bunch of complex businesses. Its financial
statements are nearly impenetrable. So why is Enron
trading at such a huge multiple?
Bethany McLean

03/05/2001
Fortune Magazine
122+
(Copyright 2001)

   In Hollywood parlance, the "It Girl" is someone who commands the
spotlight at any given moment--you know, like Jennifer Lopez or Kate
Hudson. Wall Street is a far less glitzy place, but there's still
such a thing as an "It Stock." Right now, that title belongs to
Enron, the Houston energy giant. While tech stocks were bombing at
the box office last year, fans couldn't get enough of Enron, whose
shares returned 89%. By almost every measure, the company turned in a
virtuoso performance: Earnings increased 25%, and revenues more than
doubled, to over $100 billion. Not surprisingly, the critics are
gushing. "Enron has built unique and, in our view, extraordinary
franchises in several business units in very large markets," says
Goldman Sachs analyst David Fleischer.

   Along with "It" status come high multiples and high expectations.
Enron now trades at roughly 55 times trailing earnings. That's more
than 2 1/2 times the multiple of a competitor like Duke Energy, more
than twice that of the S&P 500, and about on a par with new-economy
sex symbol Cisco Systems. Enron has an even higher opinion of itself.
At a late-January meeting with analysts in Houston, the company
declared that it should be valued at $126 a share, more than 50%
above current levels. "Enron has no shame in telling you what it's
worth," says one portfolio manager, who describes such gatherings as
"revival meetings." Indeed, First Call says that 13 of Enron's 18
analysts rate the stock a buy.
   But for all the attention that's lavished on Enron, the company
remains largely impenetrable to outsiders, as even some of its
admirers are quick to admit. Start with a pretty straightforward
question: How exactly does Enron make its money? Details are hard to
come by because Enron keeps many of the specifics confidential for
what it terms "competitive reasons." And the numbers that Enron does
present are often extremely complicated. Even quantitatively minded
Wall Streeters who scrutinize the company for a living think so. "If
you figure it out, let me know," laughs credit analyst Todd Shipman
at S&P. "Do you have a year?" asks Ralph Pellecchia, Fitch's credit
analyst, in response to the same question.

   To skeptics, the lack of clarity raises a red flag about Enron's
pricey stock. Even owners of the stock aren't uniformly sanguine.
"I'm somewhat afraid of it," admits one portfolio manager. And the
inability to get behind the numbers combined with ever higher
expectations for the company may increase the chance of a nasty
surprise. "Enron is an earnings-at-risk story,'' says Chris Wolfe,
the equity market strategist at J.P. Morgan's private bank, who
despite his remark is an Enron fan. "If it doesn't meet earnings,
[the stock] could implode."

   What's clear is that Enron isn't the company it was a decade ago.
In 1990 around 80% of its revenues came from the regulated gas-
pipeline business. But Enron has been steadily selling off its old-
economy iron and steel assets and expanding into new areas. In 2000,
95% of its revenues and more than 80% of its operating profits came
from "wholesale energy operations and services." This business, which
Enron pioneered, is usually described in vague, grandiose terms like
the "financialization of energy"--but also, more simply, as "buying
and selling gas and electricity." In fact, Enron's view is that it
can create a market for just about anything; as if to underscore that
point, the company announced last year that it would begin trading
excess broadband capacity.

   But describing what Enron does isn't easy, because what it does is
mind-numbingly complex. CEO Jeff Skilling calls Enron a "logistics
company" that ties together supply and demand for a given commodity
and figures out the most cost-effective way to transport that
commodity to its destination. Enron also uses derivatives, like
swaps, options, and forwards, to create contracts for third parties
and to hedge its exposure to credit risks and other variables. If you
thought Enron was just an energy company, have a look at its SEC
filings. In its 1999 annual report the company wrote that "the use of
financial instruments by Enron's businesses may expose Enron to
market and credit risks resulting from adverse changes in commodity
and equity prices, interest rates, and foreign exchange rates."

   Analyzing Enron can be deeply frustrating. "It's very difficult
for us on Wall Street with as little information as we have," says
Fleischer, who is a big bull. (The same is true for Enron's
competitors, but "wholesale operations" are usually a smaller part of
their business, and they trade at far lower multiples.) "Enron is a
big black box," gripes another analyst. Without having access to each
and every one of Enron's contracts and its minute-by-minute
activities, there isn't any way to independently answer critical
questions about the company. For instance, many Wall Streeters
believe that the current volatility in gas and power markets is
boosting Enron's profits, but there is no way to know for sure. "The
ability to develop a somewhat predictable model of this business for
the future is mostly an exercise in futility," wrote Bear Stearns
analyst Robert Winters in a recent report.

   To some observers, Enron resembles a Wall Street firm. Indeed,
people commonly refer to the company as "the Goldman Sachs of energy
trading." That's meant as a compliment. But the fact that part of
Goldman's business is inherently risky and impenetrable to outsiders
is precisely the reason that Goldman, despite its powerful franchise,
trades at 17 times trailing earnings--or less than one-third of
Enron's P/E. And as Long Term Capital taught us, the best-laid
hedges, even those designed by geniuses, can go disastrously wrong.
"Trying to get a good grip on Enron's risk profile is challenging,"
says Shipman.

   Nor at the moment is Enron's profitability close to that of
brokerages (which, in fairness, do tend to be more leveraged). While
Wall Street firms routinely earn north of 20% returns on their equity-
-Goldman's ROE last year was 27%--Enron's rate for the 12 months
ended in September (the last period for which balance sheet
information is available) was 13%. Even less appealing is Enron's
return on invested capital (a measure including debt), which is
around 7%. That's about the same rate of return you get on far less
risky U.S. Treasuries.

   Enron vehemently disagrees with any characterization of its
business as black box-like. It also dismisses any comparison to a
securities firm. "We are not a trading company," CFO Andrew Fastow
emphatically declares. In Enron's view, its core business--where the
company says it makes most of its money--is delivering a physical
commodity, something a Goldman Sachs doesn't do. And unlike a trading
firm, which thrives when prices are going wild, Enron says that
volatility has no effect on its profits--other than to increase
customers, who flock to the company in turbulent times. Both
Skilling, who describes Enron's wholesale business as "very simple to
model," and Fastow note that the growth in Enron's profitability
tracks the growth in its volumes almost perfectly. "People who raise
questions are people who have not gone through [our business] in
detail and who want to throw rocks at us," says Skilling. Indeed,
Enron dismisses criticism as ignorance or as sour grapes on the part
of analysts who failed to win its investment-banking business. The
company also blames short-sellers for talking down Enron. As for the
details about how it makes money, Enron says that's proprietary
information, sort of like Coca-Cola's secret formula. Fastow, who
points out that Enron has 1,217 trading "books" for different
commodities, says, "We don't want anyone to know what's on those
books. We don't want to tell anyone where we're making money."

   In addition to its commodities business, Enron has another
division called Assets and Investments that is every bit as
mysterious. This business involves building power plants around the
world, operating them, selling off pieces of them, "invest[ing] in
debt and equity securities of energy and communications-related
business," as Enron's filings note, and other things.

   Actually, analysts don't seem to have a clue what's in Assets and
Investments or, more to the point, what sort of earnings it will
generate. Enron's results from that part of its business tend to be
quite volatile--profits fell from $325 million in the second quarter
of 1999 to $55 million in the second quarter of 2000. In written
reports, Morgan Stanley chalked up the decline to the poor
performance of Enron's "significant number of investments" in telecom
stocks; Dain Rauscher Wessels blamed it on a lack of asset sales.

   In any event, some analysts seem to like the fact that Enron has
some discretion over the results it reports in this area. In a
footnote to its 1999 financials, Enron notes that it booked "pretax
gains from sales of merchant assets and investments totaling $756
million, $628 million, and $136 million" in 1999, 1998, and 1997.
"This is an enormous earnings vehicle, which can often be called upon
when and if market conditions require," notes UBS Warburg analyst Ron
Barone. Not everyone is so chipper. "We are concerned they are
liquidating their asset base and booking it as recurring revenue,
especially in Latin America," says analyst Andre Meade at Commerzbank-
-who has a hold rating on the stock. At the least, these sorts of
hard-to-predict earnings are usually assigned a lower multiple.

   There are other concerns: Despite the fact that Enron has been
talking about reducing its debt, in the first nine months of 2000 its
debt went up substantially. During this period, Enron issued a net
$3.9 billion in debt, bringing its total debt up to a net $13 billion
at the end of September and its debt-to-capital ratio up to 50%, vs.
39% at the end of 1999. Nor does Enron make life easy for those who
measure the health of a business by its cash flow from operations. In
1999 its cash flow from operations fell from $1.6 billion the
previous year to $1.2 billion. In the first nine months of 2000, the
company generated just $100 million in cash. (In fact, cash flow
would have been negative if not for the $410 million in tax breaks it
received from employees' exercising their options.)

   But Enron says that extrapolating from its financial statements is
misleading. The fact that Enron's cash flow this year was meager, at
least when compared with earnings, was partly a result of its
wholesale business. Accounting standards mandate that its assets and
liabilities from its wholesale business be "marked to market"--
valued at their market price at a given moment in time. Changes in
the valuation are reported in earnings. But these earnings aren't
necessarily cash at the instant they are recorded. Skilling says that
Enron can convert these contracts to cash anytime it chooses by
"securitizing" them, or selling them off to a financial institution.
Enron then receives a "servicing fee," but Skilling says that all the
risks (for example, changes in the value of the assets and
liabilities) are then transferred to the buyer. That's why, he says,
Enron's cash flow will be up dramatically, while debt will be "way
down, way down" when the company publishes its full year-end results,
which are due out soon.

   That's good, because Enron will need plenty of cash to fund its
new, high-cost initiatives: namely, the high-cost buildout of its
broadband operations. In order to facilitate its plan to trade excess
bandwidth capacity, Enron is constructing its own network. This
requires big capital expenditures. So broadband had better be a good
business. Both Enron and some of the analysts who cover it think it
already is. Included in the $126 a share that Enron says it's worth
is $40 a share--or $35 billion--for broadband. Several of Enron's
analysts value broadband at $25 a share, or roughly $22 billion (and
congratulate themselves for being conservative). But $22 billion
seems like a high valuation for a business that reported $408 million
of revenues and $60 million of losses in 2000. Not all analysts are
so aggressive. "Valuing the broadband business is an "extremely
difficult, uncertain exercise at this point in time," notes Bear
Stearns' Winters, who thinks that broadband, while promising, is
worth some $5 a share today.

   Of course everything could go swimmingly. Enron has told analysts
that it plans to sell between $2 billion and $4 billion of assets
over the next 12 months. The bullish scenario for Enron is that the
proceeds from those sales will reduce debt, and as earnings from new
businesses kick in, the company's return on invested capital will
shoot upward. Along with broadband, Enron has ambitious plans to
create big businesses trading a huge number of other commodities,
from pulp and paper to data storage to advertising time and space.
Perhaps most promising is its Enron Energy Services business, which
manages all the energy needs of big commercial and industrial
companies. Skilling has told analysts that its new businesses will
generate a return on invested capital of about 25% over the long run.

   But all of these expectations are based on what Wolfe, the  J.P.
Morgan strategist, calls "a little bit of the China syndrome"--in
other words, if you get x% of y enormous market, you'll get z in
revenues. For instance, Enron says the global market for broadband
and storage services will expand from $155 billion in 2001 to
somewhere around $383 billion in 2004. "Even a modest market share
and thin margins provide excellent potential here," writes Ed
Tirello, a Deutsche Bank Alex. Brown senior power strategist. The
problem, as we know from innumerable failed dot-coms, is that the y
enormous market doesn't always materialize on schedule. And Enron
isn't leaving itself a lot of room for the normal wobbles and
glitches that happen in any developing business.

   In the end, it boils down to a question of faith. "Enron is no
black box," says Goldman's Fleischer. "That's like calling Michael
Jordan a black box just because you don't know what he's going to
score every quarter." Then again, Jordan never had to promise to hit
a certain number of shots in order to please investors.

   FEEDBACK: bmclean@fortunemail.com

COLOR PHOTO: PHOTOGRAPH BY PAUL HOWELL/LIAISON
SOME PEOPLE liken Enron, with its massive trading operation, to a
Wall Street securities firm.
COLOR PHOTO: AFP
ENRON still has plenty of old-economy iron and steel assets like
this one, but it has been selling them off at a steady clip.
COLOR CHART: FORTUNE CHART
Enron's stock is soaring
Enron
S&P 500
COLOR PHOTO: PAM FRANCIS/LIAISON
JEFF SKILLING, a former consultant, has taken over the reins from
chief executive officer Kenneth Lay.



Folder Name: Enron Corp.
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