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FIN 3334 Ball State University Enrons Demise Were There Warning Signs Case Study

Fin 3334

Ball State University

FIN

Question Description

I need an explanation for this Business question to help me study.

Title: Enron's Demise--Were There Warning Signs?

Questions to answer in the report:

Evaluate Enron's profit, leverage, and cash flow performance during the period 1998-2000.

Evaluate Enron's long-run financial performance. Does the data reflect Enron's transformation from a pipeline company to a trading company?

What is your assessment of Enron's earnings quality?

Evaluate Enron's financial leverage at the end of 2000.

Enron's stock price traded around $62.72 per share at the end of April 2001. Do you think Enron was worth that much?

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For the exclusive use of Y. HE, 2020. TB0135 September 20, 2004 Enron’s Demise—Were There Warning Signs? As Andrew Amphlett leafed through Enron Corporation’s 2000 10-K filing, he realized that he was dealing with an important milestone in corporate history. Enron wasn’t just a former Fortune 500 company that had fallen from grace, but the financial scandal of the last three decades. The company’s collapse wreaked havoc on its own employees, shareholders, suppliers, and even on the entire corporate world. Amphlett’s employer, Phoenix Investments, had lost over $25 million on Enron stock, purchased not long before Enron’s stock price reached its all-time high of over $90 per share on August 23, 2000. It was now required practice for newly employed analysts at Phoenix Investments, such as Amphlett, to prepare a brief analysis of Enron’s 2000 financial statements to see what early warning signs of Enron’s collapse they could uncover. Amphlett took the standard regimen of finance and accounting courses in the MBA program he had completed in 2004, but he wondered what he could uncover in a half-hour that dozens of analysts with far more resources and better access to management had failed to notice during Enron’s heydays. Enron’s Business By the end of 2000, Enron Corporation, with revenues in excess of $100 billion, was one of the largest energy companies in the world and was ranked seventh on the Fortune 500 list of the largest companies in the U.S. Enron, headquartered in Houston, Texas, provided products and services related to natural gas, electricity, and communications to wholesale and retail customers. Enron was principally engaged in the transportation of natural gas through pipelines to markets throughout the United States; the generation, transmission, and distribution of electricity to markets in the northwestern United States; the marketing of natural gas, electricity, and other commodities and related risk management and finance services worldwide; the development, construction, and operation of power plants, pipelines, and other energy-related assets worldwide; the delivery and management of energy commodities and capabilities to end-use retail customers in the industrial and commercial business sectors; and the development of an intelligent network platform to provide bandwidth management services and the delivery of high bandwidth communication applications. Enron’s 20,600 employees conducted the company’s business in four major segments. The transportation and distribution segment included regulated industries, interstate transmission of natural gas, management and operation of pipelines, and electric utility operations. The company’s wholesale services segment focused on commodity sales and services, risk management products and financial services to wholesale customers, the development, acquisition, and operation of power plants, and natural gas pipelines and other energy-related assets. The retail energy services segment conducted the company’s sales of natural gas, electricity and related products directly to end-use customers, particularly in the commercial and industrial sectors, and the outsourcing of energy-related activities. The company’s newest segment, broadband services, facilitated the construction and management of a nationwide fiberoptic network, the marketing and management of bandwidth, and the delivery of high-bandwidth content. Copyright © 2004 Thunderbird, The Garvin School of International Management. All rights reserved. This case was prepared by Professor Graeme Rankine for the purpose of classroom discussion only, and not to indicate either effective or ineffective management. This document is authorized for use only by YUJIE HE in FIN 3334 Financial Statement Analysis taught by Shen Zhang, Troy University from Mar 2020 to May 2020. For the exclusive use of Y. HE, 2020. Major highlights of Enron’s business included the operation of over 23,000 miles of natural gas pipelines, the ownership and operation of Portland General Electric, a major electric utility operating in the Pacific Northwest of the U.S., a significant interest in the Dabhol Power Company, which developed and owned an electricity generating power plant south of Mumbai, State of Maharashtra, India, and 18,000 miles of fiber-optic network capacity throughout the United States. Company Background Enron began as a result of InterNorth’s acquisition of Houston Natural Gas for over $2.26 billion in 1985, creating a company with a 37,000-mile network of interstate pipeline, the largest in the U.S. Under the terms of the acquisition, Kenneth L. Lay, Houston Natural Gas’ chairman and chief executive, became president and chief operating officer of the new company, while Samuel F. Segnar, InterNorth’s 57-year-old chairman and chief executive officer, retained his position in the new company until succeeded by Lay on January 1, 1997.1 Lay recognized that deregulation of natural gas pricing and natural gas transmission tariffs created enormous opportunities for a large transmission network bringing gas to the growing markets in the southwest United States, particularly Texas and Florida. But with the collapse of crude oil prices in the late1980s and the exit from energy lending by major Texas banks, many small oil and gas companies were unable to finance their exploration and production programs. Traditional reserve-based loans to small operators exposed financial institutions to costly bankruptcy procedures. To participate in this type of lending, financial institutions needed expertise in traditional credit risk assessment. In the meantime, Enron hired Jeffrey Skilling, a McKinsey consultant with considerable banking experience, who developed the idea of the volumetric production payment (VPP) contract. This contact, specifically designed by Enron at considerable cost, was a claim on specific quantities of natural gas delivered over time. Enron would provide cash to the oil and gas company in exchange for a VPP contract. Enron would then have a claim on natural gas volumes. The VPP contract had the important feature that it was an equity claim on natural gas, and thus in the event of default, Enron would have a claim on the company’s natural gas reserves which it could recover by extracting natural gas from the company’s reserves. The VPP contract required expertise in assessing natural gas reserve risk, including the quantity of available reserves and the expected costs of extraction. The natural gas volumes delivered over time could be sold in the spot market to natural gas users such as utilities and commercial businesses. In effect, Skilling created a gas bank in which Enron acted as an intermediary between natural gas producers and natural gas users. But with natural gas prices experiencing considerable volatility, many producers and users also wanted some degree of price certainty upon which to base their long-run exploration and production plans. Thus, in addition to trading in the physical side of the natural gas market, Enron provided hedging opportunities to producers and users by trading natural gas derivatives as well. With an extensive pipeline network, Enron was also able to provide natural gas transportation services, thus providing a complete portfolio of products and services run under the umbrella of Enron Gas Services. To account for contracts involving future commitments to deliver and receive natural gas, Enron pioneered the use of mark-to-market accounting in which the net unrealized profits on the offsetting long and short contracts were recognized at the inception of the contract rather than the more conventional approach of recognizing them over time as the natural gas was delivered and received. Some observers believed that this approach recognized profits prematurely and failed to fully account for the risk that counterparties to the contracts would default. Up-front profit recognition also put pressure on Enron to sustain the momentum by signing new, larger deals.2 During the 1990s, Enron grew rapidly by developing, operating, and financing infrastructure projects such as pipelines, power plants in South America, Asia, and Europe. As a consequence, Enron’s stock price grew consistently, and in the late 1990s, provided investors with substantial stock returns (see Exhibit 1 for information about Enron’s stock price). To further its pursuit of related businesses, 1 2 The Wall Street Journal, May 3, 1985. TB0135 This document is authorized for use only by YUJIE HE in FIN 3334 Financial Statement Analysis taught by Shen Zhang, Troy University from Mar 2020 to May 2020. For the exclusive use of Y. HE, 2020. Enron acquired Portland General Corporation in July 1997 and Wessex Water PLC, a British water and sewage company, in July 1998 for $2.2 billion. In addition, Enron participated in other businesses including pulp and paper, metals, weather-related products, and broadband capacity. Enron’s revenues grew from $10.25 billion in 1985 to over $100 billion in 2000 (see Exhibit 2 for historical financial information). Although VPP-type contracts would generate a stream of cash flows over time as the natural gas was sold in the spot market, Enron would monetize the contracts by selling them to investors, using as conduits entities such as partnerships and corporations that were accounted for using the equity method of accounting. Under the equity method of accounting, a company shows the net investment in the entity on its balance sheet and reports only its share of the entity’s profits on its income statement. Because the entity’s assets and liabilities are not consolidated with the company’s, the entity’s debt does not appear directly on the company’s balance sheet, prompting this form of financing to be referred to as off-balance sheet financing. Enron made extensive use of the equity method of accounting (see Exhibit 3 for selected items from Enron’s 2000 10-K report). During the 1990s, a power struggle developed between two distinct factions: the faction represented by Rebecca Mark that wanted Enron to invest in hard assets such as power plants, and the faction represented by Jeffrey Skilling that thought Enron should become “asset-lite” by monetizing hard assets. The Skilling camp won out, and Rebecca Mark was shunted off to became Chairman and CEO of Azurix, an independent water company spun off from Enron. Enron’s rising stock price and rapid revenue growth drew accolades from Wall Street analysts, which further fueled the company’s stock price growth. In April 2001, after the release of the company’s 2000 10-K, SalomonSmithBarney forecasted Enron’s earnings-per-share (EPS) of $1.80 and $2.05, respectively, for 2001 and 2002, compared to $1.47 in 2000, and established a target share price of $100 per share, almost 50% more than its then-current price of $59.44.3 Similarly, Credit Suisse First Boston increased its estimated 2002 EPS for Enron from $2.20 to $2.25, with a price target of $110 per share.4 Although Morgan Stanley Dean Witter reduced their price target to $85 per share from $100, it increased its estimated EPS to $1.80 and $2.15 for 2001 and 2002, respectively.5 Enron’s Collapse On Dec. 2, 2001, Enron filed a voluntary petition for Chapter 11 reorganization with the U.S. Bankruptcy Court for the Southern District of New York. Filings for Chapter 11 reorganization were made by a total of 14 affiliated entities, including Enron North America Corp., Enron Energy Services, Enron Transportation Services, Enron Broadband, and Enron Metals & Commodity. Nonfiling entities not included were Northern Natural Gas Pipeline, Transwestern Pipeline, Florida Gas Transmission, EOTT, Portland General Electric, and numerous other international entities. On December 3, 2001, Enron arranged up to $1,500,000,000 of debtor-in-possession (DIP) financing with Citigroup and JP Morgan Chase and secured by substantially all of the company’s assets. On September 30, 2002, Enron filed a motion seeking U.S. Bankruptcy Court approval of an extension of the exclusive period during which it could file a plan of reorganization.6 During 2002, Congress conducted several House and Senate inquiries into the role played by Enron’s board of directors, the company’s top managementk, including Ken Lay, Chairman and Chief Executive Officer (CEO), Jeffrey Skilling, a former CEO, Andrew Fastow, Chief Financial Officer, and its independent accountants at Arthur Andersen. In the aftermath of the Enron scandal, Congress enacted the Sarbanes-Oxley Act in 2002 which detailed new requirements for independent directors, 2 Forbes, May 24, 1993. Enron Corporation, SalomonSmithBarney, April 17, 2001. 4 Enron Corporation, Credit Suisse First Boston, April 18, 2001. 5 Enron, Morgan Stanley Dean Witter, April 18, 2001. 6 Mergent Online. 3 TB0135 3 This document is authorized for use only by YUJIE HE in FIN 3334 Financial Statement Analysis taught by Shen Zhang, Troy University from Mar 2020 to May 2020. For the exclusive use of Y. HE, 2020. the establishment of a new Public Company Accounting Oversight Board to oversee and investigate the audits and auditors of public companies, mandated new roles for audit committees and independent auditors, and new internal control requirements. On September 10, 2003, Enron’s Treasurer, Ben Glisan Jr., pleaded guilty to conspiracy, becoming the first former Enron executive to serve time in jail, with a five-year sentence. On January 14, 2004, Andrew Fastow pled guilty to conspiracy in a deal that called for a 10-year sentence and his help in the continuing investigation. Former chief accountant, Richard Causey, pleaded innocent on January 22, 2004, to a six-count indictment including conspiracy and fraud charges. Skilling was indicted on February 22, 2004, but pled not guilty to 35 counts of widespread schemes to mislead government regulators and investors about the company’s earnings. On May 6, 2004, Lea Fastow, Andrew Fastow’s wife, pled guilty to a reduced charge of filing a false tax form, a misdemeanor, and was sentenced to one year in a federal prison, the maximum sentence. On July 8, 2004, Enron’s former CEO, Ken Lay, was indicted on 11 counts and additional charges filed by the Securities & Exchange Commission.7 Warning Signs? Amphlett’s first pass through Enron’s financial statements revealed a complex filing with many intricate footnotes, but there seemed to be few references to the infamous special purpose entities that had become synonymous with Enron’s schemes to inflate its profits and stock price. The footnotes did reveal some details of Enron’s investments accounted for using the equity method of accounting. Amphlett was also aware from graduate school that research studies showed some firms used accruals to boost earnings and that this was reflected in discrepancies between earnings and cash flows. For benchmarking purposes, Amphlett found that Enron’s Value Line beta was 0.80 (versus 1.0 for the market) and that Enron’s long-term debt rating by Moody’s was a Baa1. Moody’s reported that the average yield on Arated debt was 8.07% per year, while the average yield on Baa-rated debt was 8.37% per year. At the time, the yield on 30-year Treasury Bonds was 6.055% per year, and the commonly used risk premium at the time was around 7.5% per year, although Amphlett knew that now 5% per year was viewed as the appropriate premium. Amphlett was surprised to find that Enron’s shares closed at $62.72 at the end of April 2001. Why had investors thought it was worth that much? 7 4 The Wall Street Journal, July 8, 2004. TB0135 This document is authorized for use only by YUJIE HE in FIN 3334 Financial Statement Analysis taught by Shen Zhang, Troy University from Mar 2020 to May 2020. TB0135 Enron Enron Corporation’s Monthly Stock Price (versus the S&P 500) January 1984–December 2001 9 9 0 1 1 8 9 9 1 0 0 1 1 1 8 9 0 8 0 0 0 1 9 1 0 1 1 9 1 1 9 13 083 032 103 053 123 073 022 093 042 113 062 013 083 033 103 052 123 072 022 092 043 112 063 013 083 033 102 053 122 073 0 84 8 4 85 8 5 86 8 6 87 8 8 88 8 9 89 9 0 91 9 1 92 9 2 93 9 3 94 9 5 95 9 6 96 9 7 98 9 8 9 9 99 0 0 0 0 0 1 1 9 19 1 9 19 1 9 19 1 9 19 1 9 19 19 19 19 1 9 19 1 9 1 9 19 19 19 19 1 9 19 1 9 19 1 9 19 1 9 20 2 0 20 0.00 10.00 20.00 30.00 40.00 50.00 60.00 70.00 80.00 90.00 100.00 Exhibit 1 For the exclusive use of Y. HE, 2020. 5 This document is authorized for use only by YUJIE HE in FIN 3334 Financial Statement Analysis taught by Shen Zhang, Troy University from Mar 2020 to May 2020. 6 114 Total Stockholders' Equity 582 146 114 (7) 542 245 Operating Income After Depreciation Interest Expense Non-Operating Income/Expense Special Items Pretax Income Income Taxes - Total 361 1,719 2,243 2,062 9,596 5.19 5.19 Primary - Including EI&DO Fully Diluted - Excluding EI&DO Fully Diluted - Including EI&DO (2.33) 1.74 (2.33) 1.74 (55) 38 (218) 77 - 106 231 (53) 89 350 545 393 938 351 0.66 (3.53) 0.66 (3.53) 78 185 - (156) - (95) (203) C (10) 452 259 443 702 7,453 1,427 3,287 757 8,484 496 4,851 415 (0.90) 0.63 (1.64) 0.20 (29) (83) - 9 - (34) 20 C 164 479 335 376 711 5,916 1,716 3,428 256 9,529 571 6,429 Source: COMPUSTAT; C = items combined; na = not available 5.61 5.61 Primary - Excluding EI&DO 297 - Discontinued Operations Net Income (Loss) - 248 Extraordinary Items Income Before Extraordinary Items & Discontinued Operations (EI&DO) - 285 Depreciation, Depletion, & Amortization Minority Interest 866 Operating Income Before Depreciation Sales (Net) 79 6,303 7,510 10,253 2,031 Long Term Debt INCOME STATEMENT ITEMS 397 1,116 Notes Payable 6,122 140 3,289 Total Assets Investments at Equity Plant, Property & Equip (Net) Cash & Equivalents (In millions) 1.75 2.13 1.54 1.99 109 - (21) 94 - 35 165 175 117 433 306 389 695 5,708 1,739 3,335 - 8,695 455 6,097 131 214 3.85 3.85 4.03 4.03 226 - 0 201 0 68 295 198 158 398 337 351 688 217 560 6,598 142 636 6,473 140 697 6,723 132 1,065 6,739 115 1,216 6,868 256 1,701 7,112 170 111 288 1,374 2,656 4,433 5,036 5,294 9,170 10,657 10,681 11,743 1,856 2,983 - 3.44 3.44 3.52 3.52 202 - - 177 7 58 267 67 163 395 431 356 787 2.04 2.04 2.15 2.14 242 1 - 216 9 91 341 28 183 368 498 353 851 5,563 1,929 3,109 - 2.42 2.66 2.58 2.86 306 (7) (23) 314 18 92 446 112 41 327 620 361 981 6,325 2,547 2,459 - 1.25 1.25 1.32 1.32 333 - - 316 30 135 498 - 180 300 617 458 1,076 7,972 2,623 2,661 - 1.70 1.70 1.80 1.80 453 - - 438 51 167 671 15 223 282 716 441 1,157 8,984 2,880 2,805 - 3,723 3,349 5,618 6,254 7,048 7,357 8,550 1,679 9,570 11,470 7,151 1,001 1.94 1.94 2.07 2.07 520 - - 504 76 285 881 367 198 301 618 432 1,050 2.16 2.16 2.31 2.31 584 - - 568 109 271 964 178 382 286 690 474 1,164 0.32 0.32 0.32 0.32 105 - - 88 149 (90) 164 (714) 507 419 790 600 1,390 2.02 2.02 2.14 2.14 703 - - 686 154 175 1,032 (39) 248 616 1,439 827 2,266 1.10 1.27 1.17 1.36 893 - (131) 958 211 104 1,339 13 793 710 1,243 870 2,113 1.12 1.12 1.22 1.22 979 - - 896 231 434 1,644 121 446 876 1,953 855 2,808 9,189 13,289 20,273 31,260 40,112 100,789 3,165 3,065 - 9,849 10,424 10,664 11,504 11,966 13,239 16,137 23,422 29,350 33,381 65,503 516 6,219 9,836 13,165 1,786 3,184 - 9,105 491 6,028 109 Dec-84 Dec-85 Dec-86 Dec-87 Dec-88 Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Selected Historical Data for Enron Corporation BALANCE SHEET ITEMS Exhibit 2 For the exclu ...
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Running head: ENRON'S DEMISE - WERE THERE WARNING SIGNS?

Enron's Demise--Were There Warning Signs?
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ENRON'S DEMISE--WERE THERE WARNING SIGNS?

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Enron's Demise--Were There Warning Signs?
Introduction
The collapse of Enron Corporation is a classic example of greed gone wrong. The
company was crumbling in the Fall of the year 2000, but its CEO used a mark-to-market
accounting to hide financial losses. A special case was that the firm would build a power plant
and immediately claim a projected profit on its books of accounts. If the plant’s revenue was less
than projected, Enron transferred it to an off-the-book corporation where the loss went
unreported and made the company appear more profitable than it was. Enron believed the markto-market method allowed it to write off losses without hurting its company line (Li, 2010). To
establish whether there were warning signs, a critical evaluation of its profit, leverage, and
cashflows performance is undertaken. Also, the long-run financial performance is examined the
data during the period 1998-2000 reflects Enron’s strategic transformation.
Profit
Considering total revenue growth, it can be established that by the year 2000, the revenue
had grown by 151.27%. This will be misleading because the net income was growing at the same
rate. Even though the expenses were also increasing at the same rate of 151.43%, the net income
of the company grew by 9.63% only in 2000. This created some doubts, whether the revenue
recognition of the company was meeting the financial reporting standards. The main reason that
led to the increase of the revenue is the increase of natural gas prices in 2000, especially within
the United States of America. The trading of metals also, on the other hand, contributed 10% of
the total revenue in 2000. Nevertheless, the significant growth of the revenues of the company
cannot be justified by these factors alone.

ENRON'S DEM...

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