Why One Firm Thinks Enron Is Running Out of Gas

---------------------- Forwarded by Robert Benson/Corp/Enron on 05/11/2001
12:20 PM ---------------------------

Chris Dorland@ECT
05/11/2001 12:14 PM
To: Robert Benson/Corp/Enron@ENRON
cc:

Subject: Why One Firm Thinks Enron Is Running Out of Gas

---------------------- Forwarded by Chris Dorland/HOU/ECT on 05/11/2001 12:14
PM ---------------------------

Dan Dorland
05/11/2001 07:50 AM

To: Paul Devries/TOR/ECT@ECT, Jan Wilson/TOR/ECT@ECT, Jeff Borg/TOR/ECT@ECT,
Dave Ellis/TOR/ECT@ECT, Garrett Tripp/TOR/ECT@ECT, Stephane
Brodeur/CAL/ECT@ECT, Chris Dorland/HOU/ECT@ECT, kdorland@flint-energy.com
cc:
Subject: Why One Firm Thinks Enron Is Running Out of Gas

http://www.thestreet.com/_yahoo/comment/detox/1422781.html

Why One Firm Thinks Enron Is Running Out of Gas
By Peter Eavis
Senior Columnist
Originally posted at 5:23 PM ET 5/9/01 on RealMoney.com

A small research boutique with a reputation for rigorous analysis is telling
clients to quickly dump Enron (ENE:NYSE - news), believing that the energy
trading giant's 2001 earnings will fall well short of Wall Street's
forecasts.
Cambridge, Mass.-based Off Wall Street, led by analyst Mark Roberts, thinks
Enron's 2001 earnings will fall 6 cents short of the consensus estimate of
$1.79. The firm also believes Enron stock should trade around $30, nearly 50%
below Wednesday's $59.20.
The firm's 26-page report, published May 6, highlights Enron's declining
profitability and increasing leverage and suggests that the company should
trade on the same sort of multiple as a trading firm like Goldman Sachs (GS
:NYSE - news), which has a 2001 price-to-earnings ratio about half of Enron's
33 times. OWS also alleges that Enron's earnings quality is poor and that key
parts of its financial statements are confusing and opaque.
Houston-based Enron didn't comment by publication time on elements of the
report that Detox sent the company. An energy analyst who is bullish on
Enron's outlook says the OWS report contains fundamental misunderstandings
about the energy market and Enron's business model, but he says the report
does include some ground-breaking and valid insights. (The analyst's firm
doesn't give stock recommendations.)
Economies of Scale
Why care what Off Wall Street writes, compared with, say, analysts at Merrill
Lynch (MER:NYSE - news)? For one, OWS has an excellent track record.
Particularly sweet was 2000, when the tech stocks it had bashed came crashing
down. It has also shown itself to be well ahead of the curve, recommending
that clients sell e-tailer priceline.com (PCLN:Nasdaq - news) in June 1999,
when faith in Internet stocks was at its blindest and their prices at their
most insane.

Pulling Back
Enron retreats after long rally

Enron, with its domination of a burgeoning energy market, annual revenue of
over $100 billion and impressive earnings growth, can hardly be ranked
alongside the likes of priceline. But OWS thinks Enron is set for a
precipitous drop nonetheless. Why?
OWS's main beef is that key profitability measures are in decline. Margins on
Enron's pretax operating earnings (which the company's earnings releases call
IBIT, or income before interest, taxes and other items) are falling. Total
IBIT of $795 million in the first quarter amounted to only 1.59% of the $50
billion in revenue for the period, compared with a 2.08% margin in the fourth
quarter and 4.75% in the year-earlier period. Revenue in the first quarter
was nearly quadrupled from the year-earlier period, yet IBIT rose only 27%.
This shrinkage is due to lower-margin trading income making up an
increasingly large share of Enron's revenue base.
OWS thus calculates that for the remainder of 2001 Enron needs to generate an
extra $2.1 billion in revenue for each additional penny it makes over its
2000 EPS of $1.47 to reach analysts' expectation of $1.79.
The energy analyst counters that OWS apparently hasn't grasped how Enron can
continue to increase earnings even when margins shrink. It does so simply by
increasing volumes as the energy market balloons in size. In other words,
margins may decline, but since revenues are so much higher, earnings still go
up. Illustrating this, first-quarter 2001 EPS of 49 cents was 23% ahead of
the year-ago figure, even though the IBIT margin shrank by 3.2 percentage
points. The analyst thinks Enron will make $1.82 per share in 2001.
Growing On You
In addition, the huge growth in the energy market that has so helped Enron is
likely to continue for several years, according to the analyst. He notes that
roughly 75% of the electricity available in the U.S. still isn't traded in a
market. "Eventually it will be part of a competitive environment, but it'll
take five to 10 years," says the analyst. And he believes the extreme
volatility in energy-related commodities that has also benefited Enron will
exist for longer than OWS projects.
Still, OWS's point on profitability is bolstered by other profit measures.
Return on capital (net income as a percentage of equity plus debt) was 6.6%
in 2000, down on 1999's 6.9% and well below the 2000 returns on capital at
Duke (DUK:NYSE - news) (11.8%), Dynegy (DYN:NYSE - news) (12.1%) and even
Goldman (8.9%).
Even Enron bulls will admit that its financials are hard to follow. For
example, it doesn't give a gross margin number for its wholesale services, or
trading, business, which accounts for 96% of revenue. But one area of the
company's financial statements registered with the Securities and Exchange
Commission that consistently bugs analysts is the part that describes Enron's
related party transactions, which are the deals it does with entities that
have some sort of link to the firm. In fact, one of the related entities that
Enron has traded with is headed by Enron's CFO, Andrew Fastow. The energy
analyst comments: "Why are they doing this? It's just inappropriate."
The reason for maintaining these hard-to-follow related party deals has been
a source of speculation. But OWS analysis shows how a sales of optical fiber
to a related party may have been used to goose earnings in the second quarter
of 2000. Estimated profits from the so-called dark fiber (optical cable
without the gear to send data over it) transaction allowed Enron to beat
analysts' second-earnings earnings estimate by 2 cents a share, rather than
missing by 2 cents.
How soon before Wall Street follows Off Wall Street on Enron?