Author Topic: What was wrong with Enron's financials?  (Read 4829 times)

Nomad

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What was wrong with Enron's financials?
« on: June 16, 2019, 10:33:07 AM »
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

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Re: What was wrong with Enron's financials?
« Reply #1 on: June 16, 2019, 10:39:32 AM »
Was the reported FCF  negative those years?

coc

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Re: What was wrong with Enron's financials?
« Reply #2 on: June 16, 2019, 10:52:11 AM »
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

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Re: What was wrong with Enron's financials?
« Reply #3 on: June 16, 2019, 10:56:33 AM »
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

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Re: What was wrong with Enron's financials?
« Reply #4 on: June 16, 2019, 11:00:56 AM »
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

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Re: What was wrong with Enron's financials?
« Reply #5 on: June 16, 2019, 11:57:08 AM »
Interesting exercise. For one thing, according to Wikipedia:

Quote
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.
« Last Edit: June 16, 2019, 01:21:22 PM by writser »
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coc

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Re: What was wrong with Enron's financials?
« Reply #6 on: June 16, 2019, 05:14:16 PM »
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

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Re: What was wrong with Enron's financials?
« Reply #7 on: June 16, 2019, 06:03:22 PM »
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

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Re: What was wrong with Enron's financials?
« Reply #8 on: June 16, 2019, 06:56:07 PM »
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.
« Last Edit: June 17, 2019, 03:40:36 AM by Spekulatius »
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Grafter

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Re: What was wrong with Enron's financials?
« Reply #9 on: June 16, 2019, 07:55:30 PM »
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.