Author Topic: What was wrong with Enron's financials?  (Read 5676 times)

writser

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Re: What was wrong with Enron's financials?
« Reply #20 on: June 19, 2019, 08:45:29 AM »
Cool to read that report. Thanks.

Fascinating to see: the author seems to have a decent grasp of what is happening. He asserts Enron is not generating FCF, is skeptical about the related party transactions, even noting "These are, in effect, sales with recourse to Enron. It is unclear to what degree Enron is actually exposed to these recourse arrangements.". He notes that Enron marks investments using questionable models, is questioning the merchant asset trading profits, etc. But in the end he still comes up with a $30 / share or 26b valuation. A few months before bankruptcy! In hindsight it is easy to make fun of this, but at the time I'm not so sure I'd have done better. Very hard not to anchor to the current valuation.

This was a fun exercise and funnily enough a bit reassuring. Could I have predicted Enron was a fraud before the fact? I doubt it. Would I have been smart / ballsy enough to short it? I doubt it. But after looking at the financials for a few minutes I can say with some confidence that I would not have gone long either. Not my cup of tea. Share count increasing like crazy, selling insiders, opaque and risky balance sheet, unclear where cashflow / earnings come from, huge derivative positions, very dubious related party transactions combined with a rich valuation: I think that Enron, just like Valeant, would be on my "skeptical-but-too-hard-pile" within a few minutes, meaning I would post snarky comments from the sidelines without ever getting involved. I guess that means I'm just a very boring, conservative investor, missing out on all the fun.
« Last Edit: June 19, 2019, 08:47:00 AM by writser »
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coc

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Re: What was wrong with Enron's financials?
« Reply #21 on: June 19, 2019, 10:46:51 AM »
writser,

The “skeptical-but-too-hard” pile is just about the most important pile to have, in my judgment. You don’t have to get them all right.

I’ll also add that Chanos has said before that he thought Enron was just a bad business, overpriced, overcomplex, overlevered - he didn’t know the numbers were so cooked until after the trials.

Spekulatius

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Re: What was wrong with Enron's financials?
« Reply #22 on: June 19, 2019, 03:43:13 PM »
I look at the records from my old message board and it was clear to most of us, that first ENE was overpriced, but also risky. The derivatives and trading shenanigans were sort of known (Pg&E bankruptcy). Proving fraud is very hard, but yellow and red flags were quite possible to detect. Same is true for many other frauds that came up later. Just avoiding stocks with similat traits that show yellow flags will not get you into this mess, but you will miss some opportunities to make money as well of course.
Life is too short for cheap beer and wine.

writser

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Re: What was wrong with Enron's financials?
« Reply #23 on: February 13, 2020, 01:51:17 AM »
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LongHaul

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Re: What was wrong with Enron's financials?
« Reply #24 on: February 13, 2020, 06:47:31 AM »
I would read  Howard Schilit's Financial Shenanigans for some insights generally into frauds and some color on each of the 3 companies you mentioned.



Cigarbutt

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Re: What was wrong with Enron's financials?
« Reply #25 on: February 13, 2020, 06:50:06 PM »
^Interesting CPA journal link.
The fundamental flaws were likely difficult to effectively be detected on a prospective basis but, in retrospect, the SPEs were the main elephants in the room. After the fact, it was found that the basic tenets of FAS 140 had not been respected. Enron had retained control of the SPEs (with the CFO on board) and the economic substance and risks had not been transferred. “Sales” should not have been recorded and the SPEs should not have been consolidated. A factor leading to the difficulty in spotting the fraud was related to the leading individuals (culture) who did not only try to take advantage of reporting ambiguities but basically set up creative structures destined to fool investors, regulators and even auditors. It’s interesting because some of these guys were very smart (but somehow did not realize how this would invariably end; this happens also with authors of Ponzi schemes who seem to believe that they can permanently delay the inevitable). One of the creative features was the use of total return swaps in order to avoid GAAP reporting requirements for financial obligations. A way to appreciate their objective is to consider that their aim was to somehow revalue their book value in order to reflect market value, something which was unavailable with US GAAP (but possible to some degree with IFRS –as a “revaluation”). By capitalizing the SPEs with Enron stock, their idea was to use the stock as a hedge (assuming the stock would keep going up and not be correlated to other assets) to other SPE assets, capturing the premium allocated to the Enron stock by the Market. Abuses are bound to happen again. Even if SPE reporting criteria were then strengthened, SPV in mortgage securitizations became widely used and the problem was not the bankruptcy-remote status of the entities but the actual products being fed into them. It was very hard to assess the endurance and trend of earnings from core operations with Enron and that always signals the need for at least a heightened level of scrutiny.

@Longhaul
It’s interesting that you recommend a book whereby the author of the preceding post had made the exact same recommendation before. I remember asking you how you assessed the quality of evidence in general (I guess a relevant step if you’re looking for fraud, red flags or something) and you had answered that you sometimes focused on summaries and used consensus opinions. You’re lucky then because dissecting reports can be tedious exercises.

Spekulatius

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Re: What was wrong with Enron's financials?
« Reply #26 on: February 15, 2020, 08:17:04 AM »
Actually, even if you new nothing about the SPE, just a casual look at the balance sheet , the lack of profitability (ROIC) and valuation should have been enough to keep you away from investing in Enron.
« Last Edit: February 15, 2020, 08:20:34 AM by Spekulatius »
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RadMan24

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Re: What was wrong with Enron's financials?
« Reply #27 on: February 15, 2020, 11:12:54 AM »
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.

Can't recall if it was this book or not, but it's always useful to put together 10 years of financials which will catch any huge discrepancies that suggest deeper dives or red flags. Sometimes the 5 year does it but another 5 years really puts things in perspective. i.e. big jumps from one account to another; no corresponding impact on cash flow; boosts earnings later on.

Edit: 10 years of all statements, cash flows, earnings, balance sheet, change in equity
« Last Edit: February 15, 2020, 11:16:08 AM by RadMan24 »

Cigarbutt

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Re: What was wrong with Enron's financials?
« Reply #28 on: February 16, 2020, 08:12:27 AM »
Actually, even if you new nothing about the SPE, just a casual look at the balance sheet , the lack of profitability (ROIC) and valuation should have been enough to keep you away from investing in Enron.

1-
I guess one can uses nonspecific filters (nonspecific in the sense that the filter will not discriminate between poor profitability, high valuation multiples, fraud or else). But when fraud is involved, numbers reported cannot be relied upon and, in theory, numbers could have been presented in a way to bypass your usual filters. How do you evaluate trust? I guess investing in a large number of companies can help but I would say that a more concentrated approach does require a deeper level of evaluation for trust.

2-
This comment is not about fraud but about the difficulty in quantifying the future. Enron was profitable (these days, there are a lot of companies which require discounting of future profitability far into the future) and many described a promising future (involvement in the internet broadband sector etc). Of course, Enron used this uncertainty in order to feed the narrative and I would say the disconnect was far from obvious when looking through contemporary eyes.
https://archive.fortune.com/magazines/fortune/fortune_archive/2001/03/05/297833/index.htm
"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."

The lesson I'll keep from the Enron story is that faith is very hard to handicap and, in my humble book, rapidly results in a zero position size, which means that many lucrative bets are missed. Too bad.

rb

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Re: What was wrong with Enron's financials?
« Reply #29 on: February 16, 2020, 08:47:34 AM »
WOW! Those financials look horrible.

I mean maybe it's very easy to say that today vs. back then. But Enron was essentially an utility with a trading operation. Yet for those years that Spek posted financials, their income is below what an utility should earn. This means that the trading operation was sucking wind all that time. The cherry on the top of course comes in 2000 when they grow the business by 150% at zero margin.

But then those times were different that today. The market was going up like crazy and nobody cared about ROIC, valuation, and income. All that mattered was top line growth and your next big idea. Actually.... wait a second, maybe times were not that different.