Why One Firm Thinks Enron Is Running Out of Gas

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

=09Dan Dorland 05/11/2001 07:50 AM =09

To:=09Paul Devries/TOR/ECT@ECT, Jan Wilson/TOR/ECT@ECT, Jeff Borg/TOR/ECT@E=
CT, 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:=09=20
Subject:=09Why 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 tell=
ing clients to quickly dump Enron (ENE :NYSE - news ), believing that the e=
nergy trading giant's 2001 earnings will fall well short of Wall Street's f=
orecasts. Cambridge, Mass.-based Off Wall Street, led by analyst Mark Robe=
rts, 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, publis=
hed May 6, highlights Enron's declining profitability and increasing levera=
ge 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 p=
rice-to-earnings ratio about half of Enron's 33 times. OWS also alleges tha=
t Enron's earnings quality is poor and that key parts of its financial stat=
ements are confusing and opaque. Houston-based Enron didn't comment by pub=
lication time on elements of the report that Detox sent the company. An en=
ergy 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.) Economi=
es of Scale Why care what Off Wall Street writes, compared with, say, analy=
sts at Merrill Lynch (MER :NYSE - news )? For one, OWS has an excellent tra=
ck 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 thei=
r prices at their most insane. Pulling Back Enron retreats after long =
rally Enron, with its domination of a burgeoning energy market, annual re=
venue of over $100 billion and impressive earnings growth, can hardly be ra=
nked alongside the likes of priceline. But OWS thinks Enron is set for a pr=
ecipitous drop nonetheless. Why? OWS's main beef is that key profitability=
measures are in decline. Margins on Enron's pretax operating earnings (whi=
ch the company's earnings releases call IBIT, or income before interest, ta=
xes and other items) are falling. Total IBIT of $795 million in the first q=
uarter 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-e=
arlier 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 rev=
enue 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 m=
akes over its 2000 EPS of $1.47 to reach analysts' expectation of $1.79. T=
he 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 stil=
l go up. Illustrating this, first-quarter 2001 EPS of 49 cents was 23% ahea=
d of the year-ago figure, even though the IBIT margin shrank by 3.2 percent=
age points. The analyst thinks Enron will make $1.82 per share in 2001. Gr=
owing 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 anal=
yst. He notes that roughly 75% of the electricity available in the U.S. sti=
ll isn't traded in a market. "Eventually it will be part of a competitive e=
nvironment, but it'll take five to 10 years," says the analyst. And he beli=
eves the extreme volatility in energy-related commodities that has also ben=
efited Enron will exist for longer than OWS projects. Still, OWS's point o=
n profitability is bolstered by other profit measures. Return on capital (n=
et income as a percentage of equity plus debt) was 6.6% in 2000, down on 19=
99's 6.9% and well below the 2000 returns on capital at Duke (DUK :NYSE - n=
ews ) (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 ex=
ample, 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 th=
at 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 en=
ergy analyst comments: "Why are they doing this? It's just inappropriate." =
The reason for maintaining these hard-to-follow related party deals has be=
en a source of speculation. But OWS analysis shows how a sales of optical f=
iber 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 c=
able without the gear to send data over it) transaction allowed Enron to be=
at analysts' second-earnings earnings estimate by 2 cents a share, rather t=
han missing by 2 cents. How soon before Wall Street follows Off Wall Stree=
t on Enron? =09